The amendments
apply to both tax treaty and non-tax treaty cases, ensuring greater
alignment between outcomes for international arrangements involving
Australia and another jurisdiction irrespective of whether the
other jurisdiction forms part of Australia’s treaty
network.

1.4 Some recent decisions of the Full Court of the
Federal Court concerning the way in which Part IVA determines
whether or not a tax advantage has been obtained in connection with
an arrangement have revealed a weakness in the capacity of Part IVA
to effectively counter arrangements that, objectively viewed, have
been carried out with a relevant tax avoidance purpose.

1.5 The amendments in Schedule 1 to this Bill
address this weakness and ensure that Part IVA is effective to
counter tax avoidance.

1.6 This measure was announced by the Government on
1 March 2012.

1.7 The amendments apply to schemes that are entered
into, or commenced to be carried out, on or after 16 November 2012,
the day when the draft amendments were released for public
comment.

1.8 The amendments were prepared after consultation
with a roundtable of independent experts and with the benefit of
formal advice from senior barristers, as well as the normal
consultation processes for tax measures.

1.9 Part IVA was enacted in 1981 to overcome
deficiencies that judicial decisions had exposed in the operation
of the previous general anti-avoidance provision —
section 260 of the ITAA 1936.

1.10 The explanatory memorandum accompanying Part IVA
explained that Part IVA was ‘designed to overcome’ the
difficulties with section 260 and ‘provide — with
paramount force in the income tax law — an effective general
measure against those tax avoidance arrangements that —
inexact though the words may be in legal terms — are blatant,
artificial or contrived’ (see explanatory memorandum, Income
Tax Laws Amendment Bill (No 2) 1981).

1.11 Further, the explanatory memorandum made it
clear that the ‘test for application’ of Part IVA was
‘intended to have the effect that arrangements of a normal
business or family kind, including those of a tax planning
nature’ would be beyond the scope of Part IVA.

1.12 The distinction between tax avoidance and
legitimate commercial and family arrangements was emphasised by the
then Treasurer in his second reading speech on the Bill.
There he stated that Part IVA was not intended to ‘cast
unnecessary inhibitions on normal commercial transactions by which
taxpayers legitimately take advantage of opportunities available
for the arrangement of their affairs’.

1.13 Part IVA gives effect to this distinction by
requiring an examination of whether, having regard to eight
objective matters (including the manner in which an arrangement was
entered into, its form and substance, and the taxation results it
produces), it would be concluded that the arrangement was entered
into in the particular way it was for the sole or dominant purpose
of obtaining a tax advantage.

1.14 Part IVA does not inquire into the subjective
motives of taxpayers and it does not therefore strike at every
arrangement that is entered into with an eye to tax
minimisation. This has been established by decisions of the
High Court of Australia. Their Honours Gleeson CJ and McHugh
J said in Commissioner of
Taxation v Hart (2004) 206 ALR 207 ( Hart ) at [15]:

‘… the fact that a particular
commercial transaction is chosen from a number of possible
alternative courses of action because of tax benefits associated
with its adoption does not of itself mean that there must be an
affirmative answer to the question posed by s 177D. Taxation
is part of the cost of doing business, and business transactions
are normally influenced by cost considerations. Furthermore,
even if a particular form of transaction carried a tax benefit, it
does not follow that obtaining the tax benefit is the dominant
purpose of the taxpayer in entering into the transaction. A
taxpayer wishing to obtain the right to occupy premises for the
purpose of carrying on a business enterprise might decide to lease
real estate rather than to buy it. Depending upon a variety
of circumstances, the potential deductibility of the rent may be an
important factor in the decision. Yet, if there were nothing
more to it than that, it would ordinarily be impossible to
conclude, having regard to the factors listed in s 177D, that the
dominant purpose of the lessee in leasing the land was to obtain a
tax benefit. The dominant purpose would be to gain the right
to occupy the premises, not to obtain a tax deduction for the rent,
even if the availability of the tax deduction meant that leasing
the premises was more cost-effective than buying
them.’

1.15 It does not follow, however, that Part IVA is
incapable of applying to arrangements that also advance wider
commercial objectives. There is no ‘dichotomy’
between a ‘rational commercial decision’ and ‘the
obtaining of a tax benefit’ (see Gummow and Hayne JJ in
Hart (2004) 206 ALR
207 at [64]).

1.16 The High Court has confirmed on a number of
occasions that Part IVA will apply to an arrangement if the
particular form in which the arrangement is implemented evinces the
requisite tax avoidance purpose (see Federal Commissioner of Taxation v
Spotless (1996) 141 ALR 92 ( Spotless ) at pp 97-98 and 105, and
Hart (2004) 206 ALR
207 at [16][52] and [94]).

1.17 More particularly, as Callinan J observed in
Hart (2004) 206 ALR
207 at [94], ‘an aspect of’ the direction in Part
IVA to consider the ‘form and substance’ of a scheme
‘is whether the substance of the transaction (tax
implications apart) could more conveniently, or commercially, or
frugally have been achieved by a different transaction or form of
transaction.’

1.18 The Commissioner of Taxation (Commissioner) may
cancel a tax benefit obtained by a taxpayer in connection with a
scheme ‘to which Part IVA applies’ (see subsection
177F).

1.19 Section 177D provides that Part IVA applies to a
scheme in respect of which:

â¢ a taxpayer has obtained, or would but for
section 177F obtain, a tax benefit in connection with the scheme
(see paragraph 177D(a)); and

â¢ one or more of the persons who participated in
the scheme (or part of the scheme) did so for the sole or dominant
purpose, objectively ascertained, of enabling the taxpayer to
obtain a tax benefit in connection with the scheme (see paragraph
177D(b)).

1.20 Although the Commissioner is entitled to put his
case in relation to the scheme and the tax benefit in alternative
ways, the existence of the Commissioner’s discretion to
cancel the tax benefit does not depend upon the
Commissioner’s opinion or satisfaction that there is a tax
benefit or that, if there is a tax benefit, it was obtained in
connection with a scheme. The existence of a scheme and a tax
benefit must be established as matters of objective fact (see
Peabody v Commissioner of
Taxation (1994) 123 ALR 451 ( Peabody ) at pp
458-459).

1.21 Moreover, the ‘bare fact’ that a
taxpayer can be shown to have obtained a tax benefit in connection
with a scheme does not in itself compel the application of Part IVA
(see Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at [53] and
Callinan J at [92]). The tax benefit must be obtained in
connection with a scheme to which Part IVA
applies.

1.22 In determining whether Part IVA applies to a
scheme, the critical question — indeed the fulcrum upon which
Part IVA turns (Callinan J in Hart (2004) 206 ALR 207 at [92])
— is whether a person or persons who participated in the
scheme did so for the sole or dominant purpose of enabling the
taxpayer to obtain a tax benefit that has been so obtained.
The relevant purpose must be established objectively based on an
analysis of how the scheme was implemented, what the scheme
actually achieved as a matter of substance or reality as distinct
from legal form (that is, its end effect) and the nature of any
connection between the taxpayer and other parties (and each of the
other factors in paragraph 177D(b)). A person’s
subjective motive is irrelevant.

1.23 Gummow and Hayne JJ observed in Hart ((2004) 206 ALR 207
at [37]) that each of the concepts of ‘tax
benefit’, ‘scheme’ and ‘scheme to which
this Part applies’ have their ‘part to play’ in
deciding whether a section 177F determination is permitted, and
each of them ‘must be given operation in the interrelated way
which section 177F(1) requires’. Further (at
[36]):

‘Although it will often be convenient to
begin any consideration of the application of the Part by attending
to the operation of these elucidating and definitional provisions
[that is sections 177A and 177C], approaching a particular case in
this way must not be allowed to obscure the way in which the Part
as a whole is evidently intended to
operate.’

1.24 Implicitly, the Part IVA inquiry ‘requires
[a] comparison between the scheme in question and an alternative
postulate’ (Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at
[66]).

1.25 A comparison between the scheme and an
alternative postulate serves the Part IVA inquiry in two
ways:

â¢ first, comparisons between the tax consequences
of the scheme and the tax consequences of alternative postulates
provide a basis for identifying (and quantifying) any tax
advantages (of the relevant kind) that may have been obtained from
the scheme; and

â¢ second, a consideration of alternative
postulates may, in the course of considering the paragraph 177D(b)
matters, assist in reaching a conclusion about the purposes of the
participants in the scheme (Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at [66] to
[68]): a consideration of whether there were other ways that
the participants in the scheme could have achieved their
non-tax purposes facilitates a weighing of those purposes
against any tax purposes that can be identified.

1.26 An alternative postulate could be merely that
the scheme did not happen or it could be that the scheme did not
happen but that something else did happen.

1.27 The purpose and function of section 177C is to
define the kind of tax outcomes that a participant in the scheme
must have had the purpose of securing for the taxpayer, and which
must have been secured in connection with the scheme, if Part IVA
is to apply.

1.28 The tax outcomes with which section 177C(1) is
concerned, and which are labeled ‘tax benefits’,
are:

1.29 In order to reach a conclusion that one of the
specified outcomes has been secured, and to quantify it, it is
necessary to compare the tax consequences of the scheme in question
with the tax consequences that either would have arisen, or might
reasonably be expected to have arisen, if the scheme had not been
entered into or carried out. This involves a comparison with
an alternative postulate.

1.30 A tax consequence of a scheme or of an
alternative postulate is relevant if it arises in connection with
the scheme or with the alternative postulate. The inquiry is
not confined to the immediate tax consequences of the steps that
comprise the scheme or the alternative postulate (see
Commissioner of Taxation v
Futuris Corporation [2012] FCAFC 32 ( Futuris ) at [34]).

1.31 A number of recent decisions of the Full Federal
Court have revealed weaknesses in the way in which the tax benefit
concept in section 177C operates.

1.32 The Government is concerned that these
weaknesses may reduce the effectiveness of Part IVA in countering
tax avoidance arrangements.

Alternative bases for identifying tax
benefits

1.33 Subsection 177C(1) contains two bases upon which
the existence of a tax benefit can be demonstrated. The first
is that, absent the scheme, a relevant tax outcome ‘would
have been’ the case. The second is that, absent the
scheme, a relevant tax outcome ‘might reasonably be expected
to have been’ the case.

1.34 The first limb requires a comparison of the tax
consequences of the scheme with the tax consequences that
‘would have’ resulted if the scheme had not
occurred.

1.35 The second limb requires a comparison of the tax
consequences of the scheme with the tax consequences that
‘might reasonably be expected to have’ resulted if the
scheme had not occurred.

1.37 One approach to the first limb has been to view
it as satisfied in cases where a relevant tax advantage is exposed
by applying the taxation law to the facts remaining once the
statutory postulate has done its work in deleting the scheme.
In those cases, a tax benefit exists if it can be demonstrated that
the relevant tax advantage flows, as a matter of law, once the
scheme is assumed not to have happened. This may be referred
to as an ‘annihilation approach’. Although this
approach involves an alternative postulate, that postulate consists
solely of deleting the scheme.

1.38 Cases that appear to have been decided on the
basis of this approach to the first limb include the decisions of
the Full Court of the Federal Court in Puzey v Commissioner of Taxation
[2003] FCAFC 197 ( Puzey ) and Commissioner of Taxation v Sleight
[2004] FCAFC 94 ( Sleight ). For example, in
Puzey , at [66], Hill
and Carr JJ (with French J concurring) identified the tax benefit
on the basis that ‘had Puzey not entered into the scheme he
would not have had the deductions which became available to
him’. However, no court has expressly considered
whether this approach to the first limb is correct.

1.39 On this view, the second limb is a qualitatively
different test that may be satisfied notwithstanding an element of
uncertainty in the postulate. For example, it has been
applied in cases where the mere deletion of the scheme would not
necessarily leave a coherent state of affairs for the tax law to
apply to — where a prediction is required about facts not in
existence and/or about facts which are in existence not being in
existence. In other words, it contemplates a postulate based
on a reasonable reconstruction of either the scheme,
or of the scheme and things that happened in connection with the
scheme. This is sometimes referred to as a
‘reconstruction approach’.

1.40 The second limb has also been applied in cases
where a first limb tax benefit, resting as it does on a postulate
that the scheme merely would not have happened, would be
inconsistent with the non-tax results and consequences sought
for the taxpayer by the participants in the scheme. In those
cases a reconstruction of either the scheme, or of the scheme and
things that happened in connection with the scheme, may expose
other ways in which the non-tax results and consequences of
the scheme could have reasonably been achieved without the impugned
tax advantages (see, for example, Hart (2004) 206 ALR 207).

1.41 The High Court decisions in Peabody (1994) 123 ALR 451,
Spotless (1996) 141
ALR 92, and Hart each
concerned an application of the second limb. In each of those
cases, the postulate upon which the Commissioner relied to identify
the tax benefit was based upon what was argued to be a reasonable
expectation about how the scheme, or the scheme and things that
happened in connection with the scheme, could have been done
differently to achieve the same commercial ends.

1.42 Another view of the operation of section 177C
has become evident in a number of recent decisions.

1.43 The decision in Futuris is an example. Both at
first instance and on appeal, the underlying suggestion seems to be
that the reference in subsection 177C(1) to tax consequences that
‘would have [occurred], or might reasonably be expected to
have [occurred], … if the scheme had not been entered into or
carried out’ is a composite phrase requiring, in every case,
a postulate about what would have or might reasonably be expected
to have happened in lieu of the scheme. On this view of the
provision, ‘would have’ or ‘might reasonably be
expected to have’ represent ends of a spectrum of certainty
within which acceptable postulates must lie (see Futuris [2012] FCAFC 32 at [54],
[59], [62] and [79] and Commissioner of Taxation v Trail Brothers Steel
& Plastics Pty Ltd [2010] FCAFC 94 at [26] and
[29]). It appears to be assumed that all acceptable
postulates will involve a prediction about events or circumstances,
as opposed to a mere deletion of the scheme.

1.44 The competing constructions of section 177C have
yet to be directly considered by a court. To achieve the
intended outcome, these amendments include provisions which put it
beyond doubt that the ‘would have’ and ‘might
reasonably be expected to’ limbs of each paragraph of
subsection 177C(1) represent separate and distinct bases upon which
the existence of a tax benefit can be demonstrated.

1.45 From a policy perspective, it is desirable that
section 177C(1) should operate in this manner. As the
Explanatory Memorandum accompanying Part IVA explained, a
‘limitation’ of section 260, which Part IVA was
intended to overcome, was that once section 260 had ‘done its
job of voiding an arrangement’ it, did not ‘provide a
power to reconstruct
what was done, so as to arrive at a taxable situation (emphasis
added)’. This was typically a problem in relation to
income schemes where voiding the arrangement served to annihilate
not only the tax shelter but also the underlying economic gain as
well.

1.46 It is desirable that reconstruction be permitted
in addition to, and not to the exclusion of, voiding an
arrangement. Voiding an arrangement can be a simple and
effective way to identify the tax advantage produced by an
arrangement, particularly an aggressive arrangement directed at
obtaining income tax deductions.

Nature of the inquiry permitted in
constructing an alternative postulate

1.47 The second limb of subsection 177C(1) has been
interpreted as permitting a broad-ranging inquiry into what into
what might reasonably be expected to have happened absent the
scheme, unconstrained by the matters that must be considered under
section 177D(b) in testing purpose (see Epov v Federal Commissioner of
Taxation [2007] FCA 34 at [62]) and the limits of what
it is that the scheme has achieved (see Commissioner of Taxation v Axa Asia Pacific
Holdings Ltd [2010] FCAFC 134 ( Axa Asia ) at [131]).

1.48 Put differently, it is viewed as an open-ended
inquiry into what, if anything, the taxpayer might reasonably have
done if it had not participated in the scheme.

1.49 While a consideration of what the taxpayer did
in the commercial circumstances that existed is viewed as shedding
light on what the taxpayer would have done in the absence of the
scheme ( Commissioner of Taxation
v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49 at
[153]), the matters that can be taken into account in the inquiry
are unlimited and can include evidence from the taxpayer as to what
it would have done in the absence of the scheme (provided
foundation facts are given to support what would otherwise be a
bald speculative statement) (see McCutcheon v Federal Commissioner of
Taxation [2008] FCA 318 (2008) 168 FCR 149 at [37],
cited with approval in Axa
Asia [2010] FCAFC 134 (at [140])).

1.50 Further, it is permissible to reject an
alternative course of action on the basis that the tax costs
involved in undertaking that action would have caused the parties
to do nothing, including deferring or abandoning a wider
transaction of which the scheme was a part (see, for example,
RCI Pty Ltd v Commissioner of
Taxation [2011] FCAFC 104 ( RCI ) at [145] to [150]).

1.51 From a policy perspective, the operation of Part
IVA as a general anti-avoidance provision would be better served if
the inquiry focused on whether or not there were other ways (for
example, more convenient, or commercial, or frugal ways) in which
the taxpayer might reasonably have achieved the substance and
effect (tax implications aside) that it achieved from, or in
connection with, the scheme. That inquiry would assist in
exposing the purposes of the participants in a scheme and prevent
taxpayers who achieve substantive non-tax effects from a scheme
avoiding the normal tax consequences of what they have actually
done by arguing that they would have done something completely
different, or done nothing at all.

1.52 It is also not conducive to the effective
operation of Part IVA for the inquiry to take into account the
potential tax consequences of an alternative postulate in
determining whether it is a reasonable alternative to the
scheme.

1.53 The function of section 177C is to compare the
tax consequences of the scheme with the tax consequences of a
reasonable substitute for the scheme. Having identified a
postulate that is in other respects functionally substitutable for
the scheme, it would be undesirable to consider the tax
consequences of that postulate to be a basis for disregarding it as
unreasonable. To do so would be to allow the normal tax
consequences of what it is that the taxpayer has achieved to
function as a shield against the operation of Part IVA.

1.54 An inquiry of the kind proposed would better
assist an analysis of the purposes of the persons who participated
in the scheme and expose the tax advantages that they have in fact
enjoyed.

Deciding whether Part IVA
applies

1.55 In part, the weaknesses in the reconstruction
limb of subsection 177C(1) may be an unintended consequence of
the way that section 177D approaches the question whether Part IVA
applies to a scheme.

1.56 Under the current law, the first question to be
answered when determining whether Part IVA applies is whether a
taxpayer has obtained a tax benefit in connection with the scheme
(as defined in section 177C). Only if the answer is yes does
attention turn to the section 177D inquiry and the question whether
a participant in the scheme had the dominant purpose of securing a
tax benefit for the taxpayer in connection with the
scheme.

1.57 For instance, in RCI [2011] FCAFC 104 (at [151) the
Full Federal Court concluded it was ‘strictly
unnecessary’, in disposing of that matter, for it to consider
the paragraph 177D(b) issue as to purpose (although it did in fact
go on to consider the issue out of ‘deference to the primary
judge’s reasons and to the submissions on the hearing of the
appeal’). Similarly, a differently constituted Full
Federal Court in Futuris [2012] FCAFC 32 was
able to dismiss the Commissioner’s appeal (at [81]) without
considering the question of whether any person had the relevant tax
avoidance purpose.

1.58 This approach is undesirable from a policy
perspective. The objects of Part IVA are more likely to be
served if the analysis starts with the section 177D inquiry about
whether a person participated in a scheme for the sole or dominant
purpose of enabling the taxpayer to obtain a tax benefit.
This inquiry has two components, in that the relevant purpose must
be about a tax benefit, but it is nonetheless a single
inquiry.

1.59 The inquiry looks at how the scheme was
implemented, what it achieved as a matter of substance or reality
(that is, its end effect) and the nature of any connection between
the taxpayer and other parties. A consideration of
alternative possibilities should form part of that inquiry.
Gummow and Hayne JJ indicated in Hart (2004) 206 ALR 207 [at 66] that
subsection 177C(1) and paragraph 177D(b) must be read
together.

1.60 On 1 March 2012, the Government announced that
it would introduce amendments to ensure Part IVA continued to be
effective in countering tax avoidance schemes.

1.61 The Government’s announcement was made
after reviewing a number of judicial decisions, including the
decision of the Full Federal Court in RCI [2011] FCAFC 104, handed down on
22 August 2011. The High Court dismissed the
Commissioner’s application for special leave to appeal
against that decision on 10 February 2012.

1.62 The Government was concerned that some taxpayers
had argued successfully that they did not get a ‘tax
benefit’ because, absent the scheme, they would not have
entered into an arrangement that attracted tax — for example
— because they would have entered into a different scheme
that also avoided tax, because they would have deferred their
arrangements indefinitely or because they would have done nothing
at all.

1.63 The Government was also concerned that Part IVA
might not be working effectively in relation to schemes that were
steps within broader commercial arrangements.

1.64 Mindful that any amendments should not interfere
with genuine commercial transactions, the Government established a
comprehensive consultation process to assist it design the
amendments. That process involved setting up a roundtable of
industry representatives, legal academics and tax experts to assist
Treasury identify and explore possible approaches to clarifying the
law. It also involved the Government seeking advice on
different design options from senior members of the bar with
particular expertise in Part IVA.

1.65 The role of the roundtable was not to revisit
the policy decisions announced by the Government on 1 March
2012. The roundtable was established because of the unique
role that Part IVA plays in the income tax laws, in addition to the
normal Treasury consultation processes, to improve the legislative
response to the problems that have emerged with Part
IVA.

1.66 The roundtable process was constructive, and
significantly deepened the Government’s understanding of the
issues with Part IVA that the Government is seeking to
address.

1.67 As originally announced, the amendments were to
apply from 2 March 2012. However, the Government
announced a deferral of the application date until the release date
of the exposure draft (16 November 2012) to allow for the
additional time taken to progress the amendments to the exposure
draft stage (time that was spent in consultation) and to recognise
that the amendments may not have been in a form the public would
have readily anticipated when the measure was first
announced.

1.69 The amendments target deficiencies in section
177C, and the way it interacts with other elements of Part IVA,
particularly section 177D, as revealed by recent decisions of
the Full Federal Court.

1.70 The amendments are not intended to change the
operation of Part IVA in any other respect.

1.71 Consistent with the policy underlying Part IVA,
the amendments are intended to have the following
effects:

â¢ to put it beyond doubt that the ‘would
have’ and ‘might reasonably be expected to have’
limbs of each of the subsection 177C(1) paragraphs represent
alternative bases upon which the existence of a tax benefit can be
demonstrated;

â¢ to ensure that, when obtaining a tax benefit
depends on the ‘would have’ limb of one of the
paragraphs in subsection 177C(1), that conclusion must be
based solely on a postulate that comprises all of the events or
circumstances that actually happened or existed other than those
forming part of the scheme;

â¢ to ensure that, when obtaining a tax benefit
depends on the ‘might reasonably be expected to have’
limb of one of the paragraphs in subsection 177C(1), that
conclusion must be based on a postulate that is a reasonable
alternative to the scheme, having particular regard to the
substance of the scheme and its effect for the taxpayer, but
disregarding any potential tax costs; and

â¢ to require the application of Part IVA to start
with a consideration of whether a person participated in the scheme
for the sole or dominant purpose of securing for the taxpayer a
particular tax benefit in connection with the scheme; and so
emphasising the dominant purpose test in section 177D as the
‘fulcrum’ or ‘pivot’ around which
Part IVA operates.

It is
clear that the ‘would have’ and ‘might reasonably
be expected to have’ limbs of each of the
subsection 177C(1) paragraphs represent alternative bases
upon which the existence of a tax benefit can be
demonstrated.

It is
unclear whether the ‘would have’ and ‘might
reasonably be expected to have’ limbs of each of the
subsection 177C(1) paragraphs represent separate and
distinct bases upon which the existence of a tax benefit can be
demonstrated.

It is
clear that the ‘would have’ limbs of each of the
subsection 177C(1) paragraphs operate on the basis of a
postulate that comprises existing facts and circumstances minus the
scheme.

The
operation of the ‘would have’ limbs of each paragraph
of subsection 177C(1) is uncertain. Recent Federal Court
cases appear to have proceeded on the basis that the ‘would
have’ limb involves a prediction about events or
circumstances, as opposed to a mere deletion of the
scheme.

It is
clear that the ‘might reasonably be expected to have’
limbs of each of the subsection 177C(1)
paragraphs operate on the basis of postulates that are
reasonable alternatives to the scheme, having particular regard to
the substance of the scheme and the non-tax results and
consequences achieved by the taxpayer from the scheme, but
disregarding potential tax costs.

The
operation of the ‘might reasonably be expected to have’
limbs of each of the subsection 177C(1) paragraphs depends on
an inquiry about what other courses of action were reasonably open
to the participants in the scheme.

The
question whether Part IVA applies to a scheme starts with a
consideration of whether any person participated in the scheme for
the sole or dominant purpose of securing for the taxpayer a tax
benefit in connection with the scheme. This ensures that the
examination of the tax benefit happens in the context of examining
a participant’s purpose.

The
question whether Part IVA applies to a scheme starts with a
consideration of whether a taxpayer has secured a particular tax
benefit in connection with the scheme.

The bases for identifying tax
benefits

1.72 Schedule 1 to this Bill amends Part IVA to
address weaknesses that have come to light in how it works out
whether there is a tax benefit in connection with a scheme and what
that tax benefit is. [Schedule 1, item 5, section
177CB]

1.73 A conclusion that one of the paragraphs of
subsection 177C(1) is satisfied requires a conclusion that one of
the tax effects specified in that subsection (for example, the
inclusion of an amount of assessable income) ‘would
have’, or ‘might reasonably be expected to have’,
happened, absent a particular scheme. [Schedule 1, item 5, subsection
177CB(1)]

1.74 The new provision puts it beyond doubt that the
‘would have’ and ‘might reasonably be expected to
have’ limbs of each of the paragraphs in subsection 177C
operate as alternative bases for identifying relevant tax
effects. [Schedule 1, item 5, subsections 177CB(2) and
(3)]

Alternative bases

1.75 Whilst the Commissioner, in exercising the
discretion under subsection 177F(1) to cancel a tax benefit, is
entitled to put his or her case in alternative ways (including by
relying, in the alternative, on the different limbs of the
paragraphs in subsection 177C), the tax benefit cancelled must be a
tax benefit that has been obtained in connection with a scheme to
which Part IVA applies.

1.76 As such, the question in every case will be
whether or not it can be established, as a matter of objective
fact, that the tax benefit the Commissioner is purporting to cancel
is a tax benefit that was obtained in connection with a scheme that
was entered into or carried out with the requisite tax avoidance
purpose.

An annihilation approach

1.77 A decision that a tax effect ‘would
have’ occurred if the scheme had not been entered into or
carried out must be made solely on the basis of a postulate
comprising all of the events or circumstances that actually
happened or existed, other than those that form part of the
scheme. [Schedule 1, item 5, subsection
177CB(2)]

1.78 This provision makes it clear that, when
postulating what would have occurred in the absence of the scheme,
the scheme must be assumed not to have happened — that is, it
must be ‘annihilated’, ‘deleted’ or
‘extinguished’. Otherwise, however, the postulate
must incorporate all the ‘events or circumstances that
actually happened or existed’.

1.79 In other words, the speculation that is
permitted about any other state of affairs that might have come
about if the scheme had not been entered into or carried out is
limited to the removal of the scheme. A postulate cannot
assume the existence of events or circumstances not in existence,
nor can it assume the non-existence of events or circumstances that
are in existence (other than those that form part of the
scheme).

1.80 Under this approach, a taxpayer will have
obtained a tax benefit in connection with a scheme if it can be
demonstrated that a relevant tax effect would have flowed, as a
matter of law, from the application of the taxation law to the
facts remaining once the scheme is assumed away, that is, a tax
effect less advantageous to the taxpayer than the tax effect
secured by the taxpayer in connection with the scheme.

Example 1.1 : Postulating the absence of the scheme

Sandy
enters into a scheme from which he secures a large, up-front,
tax deduction. The scheme is structured so as to provide him
with a highly contingent right to income payable some years in the
future. The potential investment returns are speculative and
clearly subordinate to the tax deduction.

When
postulating what the tax effects would have been absent the scheme,
the events and circumstances comprising the scheme must be assumed
not to have happened, and it is impermissible to speculate about
events or circumstances that did not exist (for example, that Sandy
would have done something else that would have also secured a tax
deduction).

If
the scheme is assumed not to have happened, Sandy would not have
obtained a tax deduction. Sandy has therefore obtained a tax
benefit in connection with the scheme that is equal to the amount
of the tax deduction that he secured by entering into the
scheme.

1.81 An annihilation approach is a simple and
effective way to identify a tax benefit in a case where the mere
deletion of a scheme exposes a coherent taxable situation
— without the need to engage in any kind of
reconstruction or speculation.

1.82 Typically, this will be the case where the
scheme in question does not produce any material non-tax results or
consequences for the taxpayer.

1.83 For example, a straightforward application of
this approach would be expected to expose the same deduction
benefits as the Full Federal Court found had been obtained in
connection with the agricultural schemes at issue in
Puzey [2003] FCAFC
197 and Sleight
[2004] FCAFC 94.

1.84 Similarly, it can be expected that this approach
would be effective to expose tax benefits obtained in connection
with schemes that shelter economic gains already in
existence.

Example 1.2 : Changing the source of income

Deborah, a foreign resident, enters into an
arrangement under which assessable income that would otherwise be
derived by her from Australian sources is instead derived by her
from foreign sources with the result that it is not assessable in
Australia.

If
the scheme had not been entered into, the income would have been included in
Deborah’s assessable income because the only operation of the
scheme was to change the source of the income for taxation
purposes. The tax benefit is the reduction in Deborah’s
assessable income.

No
speculation is necessary or permitted in deciding what else might
have happened if Deborah had not entered into the
scheme.

A reconstruction approach

1.85 A decision that a tax effect ‘might
reasonably be expected to have’ occurred if a scheme had not
been entered into or carried out must be made on the basis of a
postulate that is a reasonable alternative to the scheme, having
particular regard to the substance of the scheme and its results
and consequences for the taxpayer, and disregarding any potential
tax results and consequences. [Schedule 1, item 5, subsections 177CB(3) and
(4)]

1.86 The amendment makes it clear that when
postulating what might reasonably be expected to have occurred in
the absence of a scheme, it is not enough to simply assume the
non-existence of the scheme — the postulate must represent a reasonable
alternative to the scheme, in the sense that it could reasonably
take the place of the scheme.

1.87 Such a postulate will necessarily require
speculation about the state of affairs that would have existed if
the scheme had not been entered into or carried out. This may
include speculation about the way in which connected transactions
would have been modified if they had had to accommodate the absence
of the scheme.

1.88 Under this approach, a taxpayer will obtain a
tax benefit in connection with a scheme if it can be demonstrated
that a relevant tax effect would have flowed, as a matter of law,
from the application of the taxation law to the alternative postulate; again, a tax effect that is
less advantageous to the relevant taxpayer than the tax effect
secured by the taxpayer in connection with the scheme.

Example 1.3 : Reconstructing events

Mr
and Mrs Heginbothom want to borrow money to acquire both a family
home and a holiday house that they plan to rent to
holidaymakers. They borrow the money under an arrangement in
which the repayments are applied exclusively to the borrowing in
relation to the family home. The result is that the
deductible interest payments are increased for the holiday home
borrowing and the non-deductible interest payments for the
family home borrowing are minimised.

Merely annihilating the scheme would not leave a
sensible result because there would be no borrowing at all, so some
reconstruction is necessary. It is therefore necessary to
consider what might reasonably be expected to have happened if the
scheme had not been entered into. A reasonable alternative in
this case might be that the Heginbothoms took out two loans, one
for each of the homes they wished to acquire, each of which was
entered into on normal commercial terms.

1.89 A reconstruction approach is an effective way to
identify a tax benefit in relation to a scheme that achieves
substantive non-tax results and consequences. In these cases,
simply annihilating the scheme would be inconsistent with the
non-tax results and consequences sought for the taxpayer by the
participants in the scheme.

1.90 Typically this will be the case in an income
scheme (or a withholding tax scheme) that both produces and
shelters economic gains. In such cases an annihilation
approach would be an ineffective way to expose the tax avoidance
achieved by the tax shelter, since deleting the scheme would
destroy both the gain and the shelter. In such cases, a
prediction will necessarily be required about other ways in which a
comparable gain could have been produced without the tax
shelter.

1.91 The role of the reconstruction approach in
relation to income schemes is usefully illustrated by the High
Court decision in Spotless (1996) 141 ALR 92.
There (at pp 103-104) the Court rejected a submission on behalf of
the taxpayers, in relation to paragraph 177C(1)(a), that, had they
not entered into the investment scheme, there would have been no
interest, and no amount included in their assessable income that
would satisfy the definition of ‘tax
benefit’.

‘In our view, the amount to which para (a)
refers as not being included in the assessable income of the
taxpayer is identified more generally than the taxpayers would have
it. The paragraph speaks of the amount produced from a
particular source or activity. In the present case, this was
the investment of $40 million and its employment to generate a
return to the taxpayers. It is sufficient that at least the
amount in question might reasonably have been included in the
assessable income had the scheme not been entered into or carried
out.’

1.92 A reconstruction approach may also be effective
in relation to schemes that result in a taxpayer obtaining a tax
advantage of the kind mentioned in paragraphs 177CB(1)(b), (c), (d)
and (e): a deduction benefit, a capital loss benefit, a
foreign tax offset benefit or a withholding tax benefit.

1.93 If a postulate that the scheme merely would not
have happened would be inconsistent with the non-tax results and
consequences sought for the taxpayer by the participants in the
scheme then a reconstruction of either the scheme, or of the scheme
and things that happened in connection with the scheme, may expose
other ways in which the non-tax results and consequences of the
scheme could reasonably have been achieved without the impugned tax
advantages.

1.94 This is usefully illustrated by the decisions in
Consolidated Press
[1999] FCA 1199 and in Hart (2004) 206 ALR 207.

1.95 In Consolidated Press the Full Federal
Court concluded (at [89]) that, absent the scheme, an amount of
interest on a borrowing ‘might reasonably be expected …
not to have been allowable’. In so doing, it upheld the
trial judge’s hypothesis that, had the particular scheme not
been entered into, it was reasonable to expect that the borrowed
money would have been directly invested in a foreign subsidiary and
therefore been non-deductible because of former section 79D of the
ITAA 1936. The trial judge based his hypothesis on the way in
which the actual investment had been structured ((1998) 98 ATC 4983
at 4998 per Hill J).

1.96 Similarly in Hart , where a husband and wife had borrowed money on unusual terms with
advantageous taxation consequences, the High Court concluded that
absent the scheme it was reasonable to expect the taxpayers would
have still borrowed the money (for two purposes, one private and
the other income producing) but that they would have done so on
standard financing terms rather than the special terms which had
produced the relevant tax advantages.

1.97 In each of Consolidated Press and
Hart , the reasonable
expectation as to what would have happened absent the respective
schemes was informed by the commercial results to which the schemes
were directed.

The matters to which particular regard
must be had

1.98 The amendments make it clear that in determining
whether a postulate is a reasonable alternative to the entering
into or carrying out of the scheme, particular regard must be had
to the ‘substance of the scheme’ and to ‘any
result or consequence for the taxpayer that would be achieved by
the scheme’ (tax results aside). [Schedule 1, item 5, paragraph
177CB(4)(a)]

1.99 These matters are ones to which regard must also
be had under section 177D in determining whether it would be
concluded that a person who entered into or carried out the scheme,
or any part of it, did so for the purpose of enabling the relevant
taxpayer to obtain a tax benefit.

1.100 Particular regard must be given to the specified
matters: they are not intended to be an exhaustive list of
the matters to which regard may be had.

1.101 Particular attention is directed to the
specified matters in order to ensure that postulates identified
under the reconstruction limbs of the subsection 177C(1) paragraphs
are reasonable substitutes for the scheme.

1.102 A tax advantage cannot meaningfully be linked to
a scheme by comparing the tax consequences of the scheme to the tax
consequences that would have flowed if the parties had chosen to
pursue some other objective. To provide a meaningful
comparison, the tax consequences of the scheme should be compared
with the tax consequences of an alternative that is reasonably
capable of achieving for the taxpayer substantially the same
non-tax results and consequences as those achieved by the
scheme.

Having particular regard to the substance
of the scheme

1.103 An examination of the substance of a
scheme [Schedule 1, item 5, subparagraph
177CB(4)(a)(i)] requires a consideration of its commercial and economic
substance as distinct from its legal form or
shape.

1.104 For example, in Sleight [2004] FCAFC 94, Hill J,
when considering the substance of a tea tree oil scheme, said (at
[81]):

‘There is a difference between the form
and the substance of the present scheme. In form there is an
option whether to farm alone or to employ the management
company. There is a management agreement and financing and
interest payments. The form involving pre-payment of
management fee and interest is, it may be concluded readily,
designed to increase the taxation deductions available to an
investor. The substance is, however, quite different.
As senior counsel for the Commissioner put it, in substance the
investor is a mere passive investor in what, once the tax features
are removed, is a managed fund where no deduction would be
available, or perhaps an alternative characterisation of the
substance of the scheme is an investment in shares in the land
company which at the expiration of 15 years is to own the tea tree
plantation.’

1.105 Similarly, in Hart (2004) 206 ALR 207, Gummow and
Hayne JJ (at [71]) agreed with Hill J below that the substance of
the arrangement, in form two separate loans, was in fact one
advance to be repaid by 300 instalments.

1.106 In order for a postulate to constitute a
reasonable alternative to the entering into and carrying out of the
scheme, the substance of the postulate should correspond to the
substance of the scheme.

Example 1.4 : A postulate with the same non-tax results and
consequences

Assume Paul & Co placed $1 million dollars
on deposit for 12 months for a return of $50,000, payable in
arrears. The income produced by the investment is exempt for
taxation purposes.

From
Paul & Co’s perspective, the substance of the transaction
is an investment for a fixed term carrying a right to a
non-contingent return.

A
reasonable alternative to this transaction would be an investment
of the same amount, for the same period at a comparable risk and
for a comparable return.

An
investment in ordinary shares would not represent an investment of
comparable risk and comparable return.

Having particular regard to the results
and consequences of the scheme for the
taxpayer

1.107 An examination of the results or consequences
for the taxpayer that would be achieved by the scheme (tax results
aside) [Schedule 1, item 5, subparagraph
177CB(4)(a)(i)] requires a consideration of any financial or other
consequences for the taxpayer that would be accomplished or
achieved as an end result of the scheme having been entered into
and carried out.

1.108 Such matters could include changes in the
taxpayer’s financial position that result from the scheme,
including the impact of transaction costs, such as fees, stamp
duties, payroll taxes, and also non-financial considerations, such
as the effect that the scheme has on personal or family
relationships.

1.109 The fact that the scheme satisfied certain
regulatory requirements, such as directors’ duties, workplace
health or safety requirements and environmental standards, would
also be relevant consequences of the scheme.

1.110 It would be expected that a postulate that is a
reasonable alternative to the entering into and carrying out of a
scheme would achieve for the taxpayer non-tax results and
consequences that are comparable to those achieved by the scheme
itself.

Example 1.5 : The results achieved for the taxpayer

Gadget Co negotiates, with the assistance of its
selling agent, Banker Co, to sell its Sydney factory to Widget
Co for $500,000. However, rather than transferring the
factory directly to Widget Co, Gadget Co enters into a complex
transaction that involves the factory passing through the hands of
Banker Co before it is finally transferred to Widget
Co.

Gadget Co realizes $475,000 from the transaction
and Banker Co takes the $25,000 balance. The transaction is
constructed in such a way that Gadget Co is not liable for capital
gains tax on the disposal of the property.

From
Gadget Co’s perspective, the end result achieved by the
transaction was the disposal of its factory to Widget Co for
$500,000. A reasonable alternative to the transaction, that
would have achieved the same non-tax effect for Gadget Co,
would have been for Gadget Co to dispose of the factory directly to
Widget Co for $500,000 and for Gadget Co to have paid Banker Co a
fee reflecting the value of its services in finding a
buyer.

1.111 The amendments are intended to make it clear
that the focus is on the results and consequences achieved by the
scheme for the taxpayer, as distinct from the results and
consequences achieved by the scheme for one or more of the other
participants in the scheme (compare the emphasis that was placed on
the fact that a direct sale of Axa Health to MB Health would have
denied Macquarie Bank Limited its underwriting and sell-down
fee in Axa Asia
[2010] FCAFC 134 (at [143])).

1.112 More particularly, there is no need for the
alternative postulate to involve all the same participants as the
scheme itself comprised (see, for example, the alternative
postulate relied upon by the High Court in Spotless (1996) 141 ALR
92).

Schemes within broader
transactions

1.113 Where a scheme forms part of a broader
commercial transaction, a postulate would be a reasonable
alternative to the scheme if it performs the same role in relation
to the broader transaction as the scheme itself performs,
disregarding its tax effects.

1.114 Consequently, if the scheme itself has no
non-tax results and consequences and the broader transaction
remains effective without the scheme, there would be no warrant for
an alternative postulate involving a reconstruction of the broader
transaction (compare Futuris [2012]
FCAFC 32).

1.115 Where, however, a scheme is integral to a
broader transaction in the sense that it is intertwined with the
broader transaction and facilitates it in some way, then it would
be reasonable for an alternative postulate to involve a
reconstruction of the broader transaction, so long as the
reconstruction produces the same non-tax results and
consequences as were in fact achieved by the broader
transaction.

1.116 The extent to which the broader transaction
should be reconstructed should be limited by the role the scheme
plays in that transaction.

Example 1.6 : A scheme that facilitates a broader
transaction

Assume that in order for Kerry-Anne to
secure a tax deduction for borrowing money to invest in an offshore
company (Offshore Co) it is necessary for her to interpose a
resident Australian company. She does this by using the
borrowed funds to buy shares in an Australian shelf company (Oz
Co). In turn, Oz Co buys ordinary shares in
Offshore Co. Oz Co performs no other
role.

The
Commissioner makes a Part IVA determination on the basis that the
interposition of Oz Co is a scheme to which Part IVA
applies.

Objectively viewed, the interposition of Oz Co
achieves two effects. One is securing a deduction for
interest on the borrowing, and the other is the acquisition of
shares in Offshore Co.

A
correct alternative postulate should be another way in which
Kerry-Anne could reasonably be expected to have acquired
ordinary shares in Offshore Co. An alternative postulate that
involved Kerry-Anne lending the borrowed monies to Offshore
Co would achieve a different effect. So too would be a
postulate that involved Kerry-Anne investing the borrowed
monies in a completely different company.

Disregarding tax
costs

1.117 The amendments make it clear that, in
determining whether a postulate is a reasonable alternative to the
entering into or carrying out of the scheme, regard should not be
had to any tax costs that are generated for the taxpayer by the
scheme itself or that would be generated for the taxpayer or any
other person by the postulate. [Schedule 1, item 5, subparagraph
177CB(4)(a)(ii) and paragraph
177CB(4)(b)]

1.118 In other words, potential tax liabilities are not to be taken into account in assessing
the likelihood or reasonableness of any alternative
postulate.

1.119 Tax costs that are to be disregarded include the
same tax costs that are taken into account under the purpose
inquiry in paragraph 177D(2)(d).

1.120 The disregarding of the potential liability of a
person to tax extends not just to the taxpayer and participants in
the scheme but to any person who might be a potential participant
in an alternative to a scheme.

1.121 This amendment is intended to make it clear that alternative
postulates should not be rejected as unreasonable postulates on the
grounds that the tax costs involved in undertaking those postulates
(including denial of the tax benefit impugned by the Commissioner)
would have caused the parties to either abandon or indefinitely
defer the schemes and/or the wider transactions of which they were
a part (compare RCI [2011] FCAFC 104 at
[145]-[150] and Futuris [2012] FCAFC 32 at
[71]).

1.122 The amendments provide that the first question
to be answered when determining whether Part IVA applies to a
scheme is to ask whether a participant in the scheme had the
requisite purpose of securing a tax benefit for the taxpayer in
connection with the scheme. [Schedule 1, item 5, subsections 177D(1) and
(2)]

1.123 The questions whether a tax benefit was obtained
in connection with the scheme and whether the scheme was entered
into or commenced to be carried out after 27 May 1981 follow as
subsidiary questions. [Schedule 1, item 5, subsections 177D(3) and
(4)]

1.124 To support this, an amendment is made to
subsection 177F(1) to further emphasise that an examination of Part
IVA should commence with the question whether there is a scheme to
which Part IVA applies. [Schedule 1, item 7, subsection
177F(1)]

1.125 These amendments complement section 177CB and
ensure that Part IVA operates as an integrated whole: by
emphasizing the central role of the dominant purpose test in
section 177D (described by Callinan J in Hart (2004) 206 ALR 207 at [92] as
the ‘fulcrum’ upon which Part IVA turns) and ensuring
that section 177C, whose role is to define when a tax benefit has
been obtained in connection with a scheme, is read with section
177D in the inter-related way envisaged by Gummow and Hayne
JJ in the High Court in Hart .

1.126 The amendments apply in relation to schemes that
were entered into, or that were commenced to be carried out,
on or after 16 November 2012, the date on which an
exposure draft of this Bill was released for public
consultation. [Schedule 1, item
10]

1.127 The amendments apply from that date, rather than
from some later date, such as the date of Royal Assent, to minimize
the potential for taxpayers to obtain unintended tax advantages in
the period before the amendments become law.

1.128 Section 177CA of the ITAA 1936 provides that a
taxpayer who avoids paying withholding tax on an amount on which it
would have, or could reasonably be expected to have, paid
withholding tax, absent a scheme, is taken to have obtained a tax
benefit.

1.129 The amendments bring the avoidance of
withholding tax within the list of other tax benefits set out in
section 177C. This ensures that the amendments concerning
assumptions that can be made in relation to alternative postulates
apply with equal force to withholding tax benefits. [Schedule 1, items 2 to 5 and 8 and 9, paragraphs
177C(1)(bb), (bc) and (g), section 177CA, subsection 177F(2A)
of the ITAA 1936, and paragraph 18-40(1)(a) in Schedule
1 to the Taxation Administration Act
1953)]

1.130 A number of consequential amendments are also
required by reason of the restructuring of section
177D. [Schedule 1, items 1 and 6,
paragraphs 45B(8(k), 177EA(17)(j), and
177EB(10)(f)]

STATEMENT OF COMPATIBILITY WITH HUMAN
RIGHTS

Prepared in accordance with Part 3 of the
Human Rights (Parliamentary
Scrutiny) Act 2011

General anti-avoidance
rule

1.131
This Schedule is compatible with the human rights and freedoms
recognised or declared in the international instruments listed in
section 3 of the Human Rights
(Parliamentary Scrutiny) Act 2011 .

Overview

1.132
Part IVA is the income tax law’s general anti-avoidance rule
that operates to protect the integrity of the tax law from
contrived or artificial arrangements designed to obtain a tax
advantage.

1.133
Recent court cases have brought to light some weaknesses in Part
IVA that put at risk its capacity to properly perform that
operation. The amendments made by this Schedule ensure that
Part IVA can continue to protect the integrity of the income tax
law.

Human rights implications

1.134
This Schedule ensures that the income tax law continues to be
protected from artificial or contrived schemes designed to avoid
tax, and so improves the likelihood that the income tax law applies
in the way Parliament intended. It does not change any
legislative policy.

1.135
The amendments apply from 16 November 2012; that is, from a date
before the amendments become law. 16 November 2012 was the
date on which a draft of the amendments was released for public
comment. Applying it from that date is necessary to ensure
that taxpayers are not able to benefit from artificial or contrived
tax avoidance schemes entered into in the period between that date
and the date of Royal Assent. Application from that date does
not affect the operation of any criminal law.

1.136
For those reasons, this Schedule does not engage any of the
applicable rights or freedoms.

Conclusion

1.137
This Schedule is compatible with human rights as it does not raise
any human rights issues.

Assistant Treasurer, the Hon David
Bradbury

Outline of Chapters 2 to
7

2.1
Schedule 2 inserts Subdivisions 815-B, 815-C and
815-D into the Income Tax
Assessment Act 1997 (ITAA 1997) and Subdivision 284-E
into Schedule 1 to the Taxation
Administration Act 1953 (TAA 1953). These
Subdivisions contain amendments that modernise the transfer pricing
rules contained in Australia’s domestic law. They
ensure Australia’s transfer pricing rules better align with
the internationally consistent transfer pricing approaches set out
by the Organisation for Economic Cooperation and Development
(OECD).

2.2
The amendments also ensure greater alignment between outcomes
achieved for international arrangements involving Australia and
another jurisdiction irrespective of whether the other country
forms part of Australia’s tax treaty network.

2.4
All legislative references in Chapters 2 to 7 are to the
ITAA 1997 unless otherwise stated.

Context of amendments

2.5
The amendments ensure that application of the arm’s length
principle in Australia’s domestic rules is aligned with
international transfer pricing standards, especially those of our
major investment partners. These standards are currently set
out in the OECD Transfer Pricing
Guidelines for Multinational Enterprises and Tax
Administrations as approved by the Council of the OECD
and last amended on 22 July 2010 (OECD
Guidelines).

2.6
The OECD Guidelines are widely recognised as representing
international best practice. Greater consistency with
international standards reduces uncertainty and the risk of double
taxation, and assists in minimising compliance and administration
costs.

2.7
Transfer pricing rules are critical to the integrity of the tax
system. Related party trade in Australia was valued at
approximately $270 billion in 2009, representing a
considerable proportion of Australia’s cross-border
trade flows (about 50 per cent).

2.8
Multinational trade has grown over the last decade. Further,
since 2002 the compositional change in multinational trade in
Australia has been striking. For example, whilst trade in
tangible items such as stock in trade grew by 67 per cent between
2002 and 2009, trade in highly mobile factors such as services grew
by more than 100 per cent and trade in insurance products and
interest flows grew by more than 160 per cent over the same
period.

2.9
Growth of this nature underscores the need for modern, robust
transfer pricing rules capable of dealing with complex
arrangements.

2.10
Australia’s transfer pricing rules seek to ensure that an
appropriate return for the contribution made by an entity’s
Australian operations is taxable in Australia for the benefit of
the community. The appropriate return is determined through
the application of the arm’s length principle, which aims to
ensure that an entity’s tax position is consistent with that
of an independent entity dealing wholly independently with
others.

2.11
The new rules apply the arm’s length principle by identifying
the conditions that might be expected to operate in comparable
circumstances between independent entities dealing wholly
independently with one another.

2.12
In addition, where the allocation of an entity’s profits to
an Australian or overseas permanent establishment is relevant in
determining its tax position, the arm’s length principle
ensures that the allocation is performed on the basis that the
permanent establishment was a distinct and separate entity dealing
wholly independently with the entity of which it is a part.
Under this approach the allocation of profits to the permanent
establishment is constrained to the allocation of actual income and
expenses of the entity.

Current transfer pricing
rules

2.13
Australia’s domestic transfer pricing rules are currently set
out in Division 13 of the ITAA 1936 (Division 13) and in
Subdivision 815-A. Transfer pricing rules are also contained
in Australia’s bilateral tax treaties. Division 13 is
to be repealed and Subdivision 815-A will no longer have effect
when Subdivisions 815-B and 815-C are enacted.

2.14
The rules in Division 13 generally focus on determining the
arm’s length consideration for the supply or acquisition of
property and/or services under an international agreement. By
contrast, in determining whether outcomes are consistent with the
arm’s length principle, Australia’s tax treaties and
the OECD Guidelines also allow for consideration of the totality of
arrangements that would have been expected to operate had the
entities been dealing with each other on a wholly independent
basis. This focus permits the consideration of a broad range
of methods in determining arm’s length outcomes. Such
methods include, but are not limited to, traditional transaction
methods.

2.15
Subdivision 815-A, enacted by the Tax Laws Amendment (Cross-Border Transfer
Pricing) Act (No. 1) 2012 , applies to ensure that
Australia’s tax treaty transfer pricing rules operate as
intended. The purpose of Subdivision 815-A is to
limit taxable profits being shifted or misallocated offshore.
Subdivision 815-A also provides direct access to the OECD Guidance
material and clarifies how the Subdivision should interact with
Division 820 of the ITAA 1997, which deals with thin
capitalisation.

Summary of new law

2.16
Subdivisions 815-B, 815-C and 815-D modernise and relocate the
transfer pricing provisions into the ITAA 1997 to ensure that
consistent rules apply to both tax treaty and non-tax treaty
cases. In addition, Subdivision 284-E of Schedule 1 to the
TAA 1953 contains rules related to transfer pricing
documentation. Consistent with the approaches under Division
13, the new rules in Subdivision 815-B apply the arm’s length
principle to relevant dealings between both associated and
non-associated entities.

2.17
Unlike the current transfer pricing rules in Division 13 and in
Subdivision 815-A, which both rely on the Commissioner of Taxation
(Commissioner) making a determination, Subdivisions 815-B and 815-C
are self-executing in their operation. This better aligns
Australia’s domestic transfer pricing rules with the design
of Australia's overall tax system which generally operates on a
self-assessment basis.

2.19
The authoritative statement of the arm’s length principle is
set out in Paragraph 1 of Article 9 (the associated enterprises
article) of the OECD Model Tax
Convention on Income and on Capital and the OECD
Guidelines. Paragraph 1 states:

‘[Where]
conditions are made or imposed between the two [associated]
enterprises in their commercial or financial relations which differ
from those which would be made between independent enterprises,
then any profits which would, but for those conditions, have
accrued to one of the enterprises, but, by reason of those
conditions, have not so accrued, may be included in the profits of
that enterprise and taxed accordingly.’

2.20
Each of Australia’s tax treaties includes an associated
enterprises article based on Article 9 of the OECD Model Tax
Convention. Although the application of Article 9 is
restricted to associated enterprises, Subdivision 815-B
also applies to unrelated entities.

2.21
Consistent with the current transfer pricing rules,
Subdivision 815-B does not rely on or assume a tax avoidance
motive.

2.22
Broadly, the arm’s length principle is introduced into
Australia’s domestic law by requiring actual conditions that
operate between entities in their commercial or financial relations
and which result in a transfer pricing benefit for an entity, to be
replaced with the arm’s length conditions.

2.23
The arm’s length conditions for the commercial or financial
relations are those conditions that might be expected to operate
between entities dealing wholly independently with one another in
comparable circumstances. As such,
Subdivision 815-B applies the arm’s length
principle consistent with the associated enterprises articles of
Australia’s tax treaties.

2.24
Determining the arm’s length conditions involves an analysis
of the functions performed, the assets used or contributed, and the
risks assumed or managed by the entities. From this analysis,
the most appropriate and reliable transfer pricing method, or
combination of methods, must be selected. Applying the most
appropriate and reliable transfer pricing method or methods
determines the arm’s length conditions that are applicable to
the relevant entity.

2.25
In applying the arm’s length principle, the actual conditions
arising from the commercial or financial relations between entities
must be compared to the arm’s length conditions that might
reasonably be expected to have operated between independent
entities in comparable circumstances.

2.26
The identification of arm’s length conditions must be done in
a way that best achieves consistency with the OECD Guidelines, as
well as any documents that are prescribed by regulation.

Subdivision 815-C: Arm’s length rule
for permanent establishments

2.28
Subdivision 815-C modernises Australia’s transfer pricing
rules in respect of the attribution of profits between a permanent
establishment and the entity of which it is a part.
Consistent with Australia’s current treaty practice, the
relevant business activity approach (also known as the single
entity approach) must be followed in applying Subdivision
815-C.

2.29
Broadly, the allocation of profits between a permanent
establishment and the entity of which it is a part is determined by
analysing the functions performed, the assets used or contributed,
and the risks assumed or managed by the various parts of the
business. From this analysis, the most appropriate and
reliable transfer pricing method or combination of methods should
be chosen, having regard to the circumstances of the commercial or
financial relations — bearing in mind the limitation in the
attribution process to the actual expenditure and income of the
entity.

2.30
Within this framework, applying the most appropriate and reliable
transfer pricing method or methods determines the arm’s
length profits that are attributable to the permanent establishment
of an entity.

2.31
The arm's length principle is interpreted so as to best achieve
consistency with the OECD Model Tax Convention and Commentaries, as
well as the internationally accepted OECD Guidance material.

Subdivision 815-D: Special rules for
trusts and partnerships

2.32
Subdivision 815-D sets out special rules about the way
Subdivisions 815-B and 815-C apply to trusts and
partnerships. The rules ensure that the transfer pricing
rules apply in relation to the net income of a trust or partnership
in the same way they apply to the taxable income of a
company. The Subdivisions also apply to the partnership loss
of a partnership in the same way they apply to the tax loss of a
company.

Amendments to the TAA 1953: Record keeping
and penalties

2.33
Subdivision 284-E of Schedule 1 to the TAA 1953 sets out the type
of documentation that an entity may prepare and keep in
self-assessing its tax position under Subdivision 815-B or
815-C. This documentation is referred to as transfer pricing
documentation. In order to satisfy the requirements of
Subdivision 284-E, transfer pricing documentation must be prepared
before the lodgement of the relevant tax return.

2.34
While the Subdivision does not mandate the preparation or keeping
of documentation, failing to do so prevents an entity from
establishing a reasonably arguable position. Establishing a
reasonably arguable position is one avenue through which an entity
can lower administrative penalties. However, nothing in these
amendments prevents the Commissioner from exercising a general
discretion to remit administrative penalties where appropriate (as
currently available under the law).

2.35
Other amendments to the TAA 1953 ensure that administrative
penalties can apply to tax liabilities that arise from the
Commissioner adjusting a taxpayer’s position under
Subdivision 815-B or 815-C.

2.36
If however the additional tax liability is equal to or less than
the relevant de minimis thresholds, no administrative penalty
applies.

How do Subdivisions 815-B and 815-C interact
with Australia’s tax treaties more
generally?

2.37
Subdivisions 815-B and 815-C are generally aligned with
the associated enterprise and business profits articles in
Australia’s tax treaties (generally Articles 7 and 9).
Subsection 4(2) of the International Tax Agreements Act
1953 (ITAA 1953) continues to apply in the event of an
inconsistency between Australia’s tax treaties and the
domestic transfer pricing rules.

2.38
While Subdivision 815-B and 815-C apply where an entity gets a
transfer pricing benefit in Australia, nothing in either
Subdivision prevents Australia’s tax treaties from
applying in circumstances where a tax treaty results in a different
adjustment relative to a taxpayer’s position under the
domestic law provisions.

Comparison of key
features of new law and current law

New
law

Current law

Transfer pricing
adjustments

A
transfer pricing adjustment may be made under Subdivision
815-B, Subdivision 815-C, or the relevant transfer
pricing provisions of a tax treaty .

Subdivision 815-B applies to certain conditions
between entities and Subdivision 815-C applies to the allocation of
actual income and expenses of an entity between the entity and its
permanent establishment.

To
the extent they have the same coverage as the equivalent tax treaty
rules, an adjustment under Subdivision 815-B or
Subdivision 815-C gives the same result as the transfer
pricing provisions of a tax treaty.

A
transfer pricing adjustment may be made under Division 13, the
transfer pricing provisions of a tax treaty, or Subdivision
815-A.

Subdivision 815-A, for practical purposes,
generally gives the same result as the application of the transfer
pricing provisions of a tax treaty by adopting the terms and text
of the relevant parts of the transfer pricing articles contained in
Australia’s tax treaties.

Assessment of transfer pricing
adjustments

Subdivisions 815-B and 815-C apply
on a self-assessment basis.

The
Commissioner must make a determination under Division 13 or
Subdivision 815-A in order to give effect to a transfer pricing
adjustment.

Application of the rules to
conditions between entities

Subdivision 815-B applies to conditions that
satisfy the cross-border test, irrespective of whether
entities are associated or not and/or operating in treaty or
non-treaty countries.

The
transfer pricing provisions of a tax treaty may apply in the event
of an inconsistency with
Subdivision 815-B.

Division 13 applies to international agreements
between both associated and unassociated entities irrespective of
tax treaty coverage (although the transfer pricing provisions of a
tax treaty may apply in the event of an
inconsistency).

Subdivision 815-A and the tax treaty transfer
pricing provisions apply in treaty cases and in respect of
associated entities only.

Allocation of profits between
entities and their permanent establishments

Subdivision 815-C applies to the allocation of
actual income and expenses of an entity between the entity and its
permanent establishment.

Subdivision 815-C applies to a foreign
permanent establishment of an Australian resident and to an
Australian permanent establishment of a foreign resident entity,
irrespective of whether a tax treaty
applies.

The
transfer pricing provisions of a tax treaty may apply in the event
of an inconsistency with
Subdivision 815-C.

Subdivision 815-A and the relevant tax treaty
transfer pricing provisions allocate profits (the income and
expenses) to the Australian permanent establishment of a foreign
resident entity in treaty cases only.

The transfer pricing provisions of a tax treaty
may apply in the event of an inconsistency with
Subdivision 815-A.

Arm’s length
principle

Subdivisions 815-B and 815-C and the
tax treaty transfer pricing provisions apply the internationally
accepted arm’s length principle which is to be determined
consistently with the relevant OECD Guidance
material.

Division 13
operates to ensure that for all purposes of the Act, an arm’s
length amount of consideration is deemed to be paid or received for
a supply or acquisition of property or services under an
international agreement.

Subdivision 815-A
and the tax treaty transfer pricing provisions apply the internationally accepted arm’s
length principle which is to be determined consistently with the
relevant OECD Guidance material.

Record
keeping

Subdivision 284-E of Schedule 1 to the TAA 1953
sets out optional record keeping requirements for entities to which
Subdivision 815-B or 815-C applies.

Records that meet the requirements are
necessary, but not sufficient to establish a reasonably arguable
position for the purposes of Schedule 1 to the TAA
1953.

If
the documentation as specified in the Subdivision is not kept in
respect of a matter, an entity is not able to demonstrate that it
has a reasonably arguable position in relation to that matter for
the purposes of Schedule 1 to the
TAA 1953.

The general record-keeping provisions of the tax
law apply to the transfer pricing provisions.

Administrative
penalties

Administrative penalties may apply if an
assessment is amended by the Commissioner for an income year to
give effect to Subdivisions 815-B or 815-C and the
provisions of section 284-145 of
Schedule 1 to the TAA 1953 have been
met.

Administrative penalties may apply where a
transfer pricing adjustment has been made by the
Commissioner under Division 13 or Subdivision 815-A and
the provisions of section 284-145 of
Schedule 1 to the TAA 1953 have been met.
This is subject to the operation of a transitional rule where the
Commissioner makes a determination under
Subdivision 815-A in respect of income years prior to
the first income year starting on or after
1 July 2012.

Amendment
period

An
amendment to give effect to Subdivision 815-B or
Subdivision 815-C can be made within seven years after
the day on which the Commissioner gives notice of the assessment to
the entity.

Some
tax treaties impose specific time limits in relation to transfer
pricing adjustments under the tax treaty.

Subject to subsection 170(9C), subsection
170(9B) of the ITAA 1936 provides an unlimited period in which the
Commissioner may amend an assessment to give effect to a transfer
pricing adjustment under Division 13, the tax treaty transfer
pricing provisions, or Subdivision 815-A.

Some tax treaties impose specific time limits in
relation to transfer pricing adjustments under the tax
treaty.

Subdivision 815-B

What is the object of Subdivision
815-B?

3.1
The object of Subdivision 815-B is to ensure that the amount
brought to tax in Australia from cross-border conditions that
operate between entities reflects the arm’s length
contribution made by an entity’s Australian operations.
Any such amounts should reflect the conditions that might be
expected to operate between independent entities dealing at
arm’s length. [Schedule 2, item 2,
subsection 815-105(1)]

3.2
Subdivision 815-B seeks to achieve this outcome in a way that
facilitates trade and investment through alignment with
international standards. The international standard that is
widely accepted by Australia’s trade and investment partners
is the arm’s length principle, the application of which is
set out in the Organisation for
Economic Cooperation and Development (OECD)
Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations as
approved by the Council of the OECD and last amended on 22 July
2010 (OECD Guidelines).

3.3
The Subdivision implements this principle by requiring entities
that would otherwise get a tax advantage in Australia from
non-arm’s length conditions, to calculate their
Australian tax position as though the arm’s length conditions
had instead operated. [Schedule 2, item 2,
subsection 815-105(2)]

How does Subdivision 815-B interact with the
rest of the Act?

3.4
Subdivision 815-B takes precedence over other provisions of the
Income Tax Assessment Act
1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA
1997) unless a limitation to its operation is explicitly provided
within the Subdivision. [Schedule 2, item 2,
subsection 815-110(1)]

3.5
This means that to the extent that an entity is liable to a
different tax result under Subdivision 815-B relative to other
provisions of the tax law because of the operation of arm’s
length conditions instead of actual conditions, Subdivision 815-B
must be applied in working out the entity’s Australian tax
liability.

3.6
This priority rule does not however overcome the effect of
subsection 4(2) of the International Tax Agreements Act
1953 (ITAA 1953) (referred to at paragraphs 2.37
and 2.38 above). This is because Subdivision 815-B takes
precedence over provisions in the ITAA 1936 and the ITAA 1997
(the Assessment Acts), whereas subsection 4(2) applies to the
extent of inconsistencies between the ITAA 1953 and the
Assessment Acts.

3.7
Subdivision 815-B does not limit the application of Division 820
(which is about thin capitalisation) in reducing, or further
reducing, an entity’s debt deductions. [Schedule 2, item 2,
subsection 815-110(2)]

3.8
This rule preserves the role of Division 820 in its application to
an entity’s amount of debt. In addition to this rule,
Subdivision 815-B contains other special rules that apply in
working out an entity’s transfer pricing adjustment where
Division 820 also applies (these rules are described in further
detail below at paragraphs 3.143 to 3.149).

3.9
In contrast to former subsection 136AB(2) of the ITAA 1936,
Subdivision 815-B does not disregard the effect of sections 70-20,
420-20, 420-30 or 355-400 (which relate to market value
amounts). A rule of this kind is not required under
Subdivision 815-B because in the event that a market value
substitution has already been applied under one of those provisions
(or a similar provision), Subdivision 815-B still applies to the
extent that an adjustment under Subdivision 815-B is greater than
the market value amount.

3.10
Conversely, where the market value amount is greater than the
adjustment under Subdivision 815-B, Subdivision 815-B does not
apply where the market value amount has already been substituted
(because the entity does not have a transfer pricing
benefit). Similarly, if Subdivision 815-B were to be
applied before the market value amount has been substituted,
sections 70-20, 420-20, 420-30 or 355-400 (or a similar provision)
would continue to apply to the extent of the difference between
Subdivision 815-B and the market value amount. These outcomes
are consistent with those that applied under Division 13 of the
ITAA 1936 (Division 13), given that Division 13 relied upon
the Commissioner of Taxation (Commissioner) issuing a determination
and this would only have occurred where the arm’s length
consideration under former section 136AD of the ITAA 1936
exceeded the market value amount.

Working out an entity’s tax
position

3.11
Subdivision 815-B applies where an entity gets a transfer pricing
benefit in an income year from conditions that operate between the
entity and another entity in connection with their commercial or
financial relations. In such instances, the actual conditions
are taken not to operate and instead, the arm’s length
conditions are taken to operate for the purposes of working out the
amount to which the transfer pricing benefit relates.
[Schedule 2, item 2, subsection
815-115(1)]

3.12
These amounts can be the amount of an entity’s taxable
income, a loss of a particular sort or tax offsets for an income
year, as well as withholding tax payable in relation to interest or
royalties. [Schedule 2, item 2,
subsection 815-115(2)]

3.13
A tax loss, film loss or net capital loss are all identified by
subsection 701-1(4) as a loss of a particular sort.

3.14
For simplicity, the process of working out the amount of an
entity’s taxable income, a loss of a particular sort, tax
offsets for an income year, or an amount of withholding tax payable
in relation to interest or royalties on the basis of arm’s
length conditions, is referred to in this Explanatory Memorandum as
working out ‘an entity’s tax outcome under arm’s
length conditions’.

3.15
After an entity’s arm’s length conditions are
identified, whether and how those conditions would affect the
entity’s Australian tax result (and any elements in the
calculation of its tax result under the relevant sections of the
tax law) must be considered.

3.16
In contrast to the transfer pricing rules that were introduced by
Subdivision 815-A (in particular, section 815-30), Subdivision
815-B does not contain an explicit rule requiring individual
amounts to be specified. A rule of this kind is not necessary
because under Subdivision 815-B an entity is required to
work out its taxable
income, loss of a particular sort, tax offsets or withholding tax
payable on the basis that independent conditions operated.
This process is different from simply making an overall adjustment
to these amounts (as was permitted under Subdivision 815-A)
and by definition allows and requires the identification and
valuing of items that are relevant in determining the aggregated
amounts.

3.17
As such, even if a profit based method is used in applying
Subdivision 815-B, taxpayers (and the Commissioner in the case of
an amended assessment) must attribute the arm’s length
conditions to the value of individual components that form part of
the tax equation. The determination of an entity’s tax
position must therefore include all questions (for example the
identification of specific amounts of income and expenditure) that
would ordinarily be considered in calculating any elements of the
entity’s tax position.

3.18
One example of this type of consideration would be where the
question of source is relevant to an entity’s Australian tax
position. This could occur where the entity is a foreign
resident or where source is relevant in calculating the
entity’s tax position insofar as it impacts upon other
entities (for example, where the entity is a trust or partnership
with foreign resident beneficiaries or partners). In such
cases, the question of whether the arm’s length conditions
would have resulted in an amount of Australian sourced income being
made by the entity may need to be determined.

Working out withholding tax under Subdivision
815-B

3.19
If a taxpayer receives a transfer pricing benefit in relation to
withholding tax, the actual conditions are substituted with the
arm’s length conditions for the purpose of working out the
amount of withholding tax payable in respect of interest or
royalties. The effect of substituting the actual amount with
the arm’s length amount is that the actual amount is treated
as never having been paid or received, and that for all purposes of
the Act, the arm’s length amount was received in accordance
with the arm’s length conditions.

3.20
In such circumstances, the time the liability to withholding tax
under the arm’s length conditions arises is determined by
those conditions (as opposed to when an adjustment to the actual
conditions is made).

3.21
The omission of ‘for the income year’ from
paragraph 815-115(2)(d) requires the working out of
withholding tax be based on the receipt of the royalty or interest
payment to which the arm’s length conditions related.
Assuming there had been an actual payment it would generally be
reasonable to conclude that the timing of the arm’s length
payment would have been the same (unless the arm’s length
conditions changed this timing).

Guidance material

3.22
Applying the arm’s length principle is the internationally
accepted approach to dealing with transfer pricing issues.
The OECD Guidelines, in particular, expand on the application of
the arm’s length principle and contain authoritative
international know-how on the application of transfer pricing
rules. The OECD Guidelines are widely used by both member and
non-member tax administrations, and were described by the UK
Special Commissioners as ‘the best evidence of international
thinking on transfer pricing’. [3]

3.23
In establishing the effect of Subdivision 815-B for an entity, the
identification of arm’s length conditions must be done in a
way that best achieves consistency with prescribed guidance
material. The OECD Guidelines are included as guidance
material under Subdivision 815-B. [Schedule 2, item 2, subsection 815-135(1) and
paragraph 815-135(2)(a)]

3.24
The OECD’s Committee on Fiscal Affairs (CFA) is the primary
international tax policy forum for Australia and other developed
countries. The OECD Guidelines are initially developed by
working parties of the CFA, vetted by that Committee, and finally
approved or adopted at Council level. Australia is
represented at each of these stages and the OECD consults
extensively with the international business community as part of
this process.

3.25
Most of Australia’s major trading and investment partners
look to the OECD Guidelines to ensure consistent application of
transfer pricing rules. In the event that different standards
were used there would be a greater risk that jurisdictions might
each tax the same amount under their transfer pricing rules
(resulting in double taxation), or not tax an amount at all
(leading to double non-taxation).

3.26
The identification of arm’s length conditions under
Subdivision 815-B must be done in a way that best achieve
consistency with the following material:

â¢
the OECD Guidelines; and

â¢
any other documents, or part(s) of a document, prescribed by the
regulations for this purpose.

[Schedule 2, item
2,
subsection 815-135(2)]

3.27
Insofar as it is possible, the OECD Guidance material is to be used
in all cases to determine the arm’s length conditions.
That is, the Guidance material is relevant in applying the
Subdivision to dealings between associated entities and equally to
dealings between non-associated entities, and in both treaty
and non-treaty cases. Although the OECD Guidelines refer to
associated enterprises or related parties, it is intended that in
the context of Subdivision 815-B such references be read as
references to entities not dealing wholly independently with one
another.

3.28
This approach to the use of OECD Guidance material is consistent
with the intended operation of former Division 13 (which the
amendments in this Schedule replace).

3.29
Similarly, some aspects of the OECD Guidelines assume that transfer
pricing adjustments will be made by the tax administrations rather
than the taxpayer. Because Subdivision 815-B operates on the
basis of self-assessment, where appropriate the references in the
OECD Guidelines to tax administrations making adjustments, taking
actions, or being prevented from taking actions should be read as
references to whoever is applying the rules (which may be the
taxpayer or the Commissioner).

Regulation making powers in relation to
documents

3.30
Regulation making powers are included to allow for modifications to
the list of guidance material. Requiring that such
modifications be prescribed by regulation strikes an appropriate
balance between ensuring ongoing consistency with developing
international arrangements while providing for Parliamentary
scrutiny of future developments.

3.31
The regulation making powers include the ability to prescribe
additional documents or parts of a document. [Schedule 2, item 2, paragraph 815
135(2)(b)]

3.32
These powers ensure sufficient flexibility to prescribe further
guidance material that may be published by the OECD or by other
organisations that may be relevant for interpretive purposes in the
future. Such material might be supplementary in nature or
address issues that are not considered in the current OECD Guidance
material.

3.33
The OECD Guidelines may also be removed from the list of guidance
material by regulation. This allows material to be removed in
the event that it is no longer relevant to determining the
arm’s length conditions of an entity. [Schedule 2, item 2,
subsection 815-135(3)]

3.34
It may be appropriate to remove a document where it is subsequently
revised in such a way that it is no longer relevant, or if an
alternate model or guidance material is adopted in the
future. The regulation making power may also remove a part of
a document; this power may be used, for example, where Australia
reserves its position on part of a document.

3.35
Regulations may also prescribe which documents, or parts of
documents, are to be used or removed in specific
circumstances. [Schedule 2, item 2,
subsection 815-135(4)]

3.36
An example of this would be where a document explains a specific
approach that should be adopted in relation to a certain
arrangement in a specific industry but would result in an
inappropriate outcome for similar arrangements in all other
industries. In such cases it may be appropriate to prescribe
that document as relevant guidance material, but confine its
application to particular arrangements or industries.
Alternatively, a regulation that removes a document specified from
the guidance provision may prescribe the circumstances in which
those documents are to be disregarded.

When does an entity get a transfer pricing
benefit?

3.37
The term ‘transfer pricing benefit’ describes the
shortfall amount of Australian tax that an entity has as the result
of its non-arm’s length dealings with other
entities. In the context of a self-assessed position under
these rules, this tax advantage is a notional one as it would only
be realised in the absence of the entity applying
Subdivision 815-B.

3.38
An entity gets a transfer pricing benefit in an income year from
conditions that operate between the entity and another entity in
connection with their commercial or financial relations if:

â¢
the actual conditions differ from the arm’s length
conditions;

â¢
the actual conditions result in a tax advantage in Australia,
relative to the arm’s length conditions; and

â¢
the actual conditions satisfy the cross-border test.

[Schedule 2, item
2,
subsection 815-120(1)]

3.39
While the Subdivision only operates where the entity would
otherwise have received a tax advantage in Australia, it does not
rely on or assume any tax avoidance purpose or motive.

What are ‘commercial or financial
relations’?

3.40
The term ‘commercial or financial relations’ describes
the totality of arrangements related to the interactions of two
entities. The term is particularly relevant in identifying
actual and arm’s length conditions, and can be seen as the
context in which each set of conditions arises.

3.41
It is intended that ‘commercial or financial relations’
be sufficiently broad so as to take into account any connections or
dealings between the entities that relate to or could otherwise
affect the commercial or financial activities of one of the
entities.

3.42
In this regard, ‘commercial or financial relations’
could include (but are not limited to) one or more of the
following:

â¢
a single transaction or a series of transactions;

â¢
a practice, understanding, arrangement, thing to be done or not be
done, whether express or implied and whether or not legally
enforceable;

â¢
the options realistically available to each entity;

â¢
unilateral actions or mutual dealings;

â¢
a strategy; or

â¢
overall profit outcomes achieved by the entities.

What are the actual
conditions?

3.43
Conditions that operate in connection with the commercial or
financial relations of two entities are the things that ultimately
affect each of the entities’ economic or financial
positions. Conditions need not be explicit contractual terms,
but can include the price paid for the sale or purchase of goods or
services, terms of an agreement that have an economic impact (such
as the allocation of an expense), the margin of profits earned by
one or both the entities, or a division of profits between the
entities.

3.44
The ‘actual conditions’ are therefore those conditions
that did in fact operate in connection with the actual commercial
or financial relations of the entities.

3.45
In cases where the multinational enterprise has a relatively
straightforward value chain and there is clarity regarding the
identification, location and ownership of key profit drivers in
that value chain, relevant conditions might include the price at
which trading stock items are sold or the fees charged for common
services such as transportation or freight.

The actual conditions must differ from the
arm’s length conditions

3.46
In determining whether an entity gets a transfer pricing benefit,
the conditions which operate between the entity and another entity
in connection with their commercial or financial relations must
differ from the arm’s length conditions. [Schedule 2, item 2,
paragraph 815-120(1)(a)]

3.47
A difference will exist when arm’s length conditions and
actual conditions are not the same.

3.48
A difference will also exist where an actual condition exists that
is not one of the arm’s length conditions, or a condition
does not exist in the actual conditions but is one of the
arm’s length conditions. [Schedule 2, item 2,
subsection 815-120(2)]

The actual conditions result in a tax advantage
in Australia relative to the arm’s length
conditions

3.49
Subdivision 815-B requires an assessment of what an entity’s
Australian tax position would have been had the arm’s length
conditions operated.

3.50
Assessing what the entity’s tax position would have been
requires a comparison between the arm’s length conditions and
the actual conditions. In order to have a transfer pricing
benefit, it must be demonstrated that the entity would have
received a tax advantage in Australia because of the operation of
non-arm’s length conditions.

3.51
An entity has a tax advantage of this kind where under arm’s
length conditions, relative to actual conditions:

â¢
the amount of the entity’s taxable income for the income year
would have been greater ;

â¢
the amount of the entity’s loss of a particular sort for the
income year would have been less ;

â¢
the amount of the entity’s tax offsets for the income year
would have been less ;
or

â¢
the amount of the entity’s withholding tax payable in respect
of interest or royalties would have been greater .

[Schedule 2, item
2,
paragraph 815-120(1)(c)]

3.52
In general terms, an increase in an entity’s income or a
decrease in an expense under arm’s length conditions relative
to actual conditions would generally result in that entity having a
greater amount of assessable income or a reduction in an allowable
deduction in an income year. All things being equal, this
would be expected to result in the entity having a greater amount
of taxable income or a lesser amount of a tax loss (which is a loss
of a particular sort) for the income year.

3.53
Where a change in an amount of profit or component amounts of
profit (for example, certain amounts of revenue or expense) would
not have affected an entity’s Australian tax position, the
entity does not have a tax advantage of the kind referred to
above. For example, if an amount of profit that might have
been expected to have accrued to an entity would have been
non-assessable, non-exempt income of the entity, then the
entity would not have a transfer pricing benefit in respect of that
amount.

3.54
Where an entity receives a royalty or interest payment in an income
year that is subject to withholding tax (for example the entity is
a foreign resident company that receives a royalty payment from an
Australian resident company), and under arm’s length
conditions the payment would have been expected to have been
greater, the entity would generally not be expected to have a
greater amount of taxable income or a lesser amount of a tax
loss. This is because income that is subject to withholding
tax is generally non-assessable, non-exempt income due to the
operation of section 128D of the ITAA 1936. In such
circumstances however, the entity would be expected to have had a
greater amount of withholding tax payable. As such, the
entity would have a transfer pricing benefit in respect of that
amount.

Determining whether an entity gets a transfer
pricing benefit when there is no taxable income, loss of a
particular sort, tax offsets

3.55
An assessment of whether an entity receives a tax advantage of the
kind referred to above, as well as the amount of any such benefit,
requires consideration of the difference between two amounts: the
first being based on the actual conditions that operate between
entities, and the second being based on the arm’s length
conditions that might be expected to operate between entities and
which is ascertained in accordance with the arm’s length
principle.

3.56
In instances where an entity has no taxable income, no loss of a
particular sort, or no tax offset in an income year, it is not
correct to say that the entity has a nil amount (rather it has no
amount at all).

3.57
To ensure that the necessary calculation can still be performed
where an entity has no actual taxable income, no losses of a
particular sort, or no tax offsets (or would not have had such an
amount under arm's length conditions), a rule is included to deem
the entity to have a taxable income, loss of a particular sort, or
tax offsets equal to an amount of nil (as appropriate) in the
income year. This allows the relevant amount to be compared
with the nil amount (or amounts). [Schedule 2, item 2,
subsection 815-120(5)]

3.58
A similar rule is not required in respect of withholding tax,
however, because in cases where an entity has no withholding tax
payable, the amount of withholding tax payable can still
appropriately be described as nil.

The actual conditions must satisfy the
cross-border test

3.59
In order for an entity to get a transfer pricing benefit in an
income year, the actual conditions that operate between that entity
and another entity must satisfy the cross-border test.
[Schedule 2, item 2,
paragraph 815-120(1)(b)]

3.60
The cross-border test is consistent with former section 136AC of
the ITAA 1936 and ensures that Subdivision 815-B does not apply to
purely domestic arrangements.

3.61
The test applies to the conditions that operate between two
entities in connection with their commercial or financial
relations. Although the test examines the conditions from the
perspective of each entity individually, it is satisfied where
either entity meets its requirements. [Schedule 2, item 2,
section 815-120(3)]

3.62
The cross-border test is satisfied in relation to conditions that
operate between entities where the ‘overseas
requirement’ for those conditions is satisfied by either or
both of the entities. Different overseas requirements apply
in relation to different types of entities. [Schedule 2, item 2,
paragraph 815-120(3)(a)]

3.63
Where one of the entities is an Australian resident, a resident
trust estate or a partnership in which all of the partners are
ultimately Australian residents, the overseas requirement will be
met where the conditions operate at or through an overseas
permanent establishment of that entity. [Schedule 2, item 2, table item 1 in
subsection 815-120(3)]

3.64
Where one of the entities is not an Australian resident, is not a
resident trust estate, and is not a partnership in which all of the
partners are ultimately Australian residents, the overseas
requirement will be met where the conditions do not operate solely at or through an
Australian permanent establishment of that entity.
[Schedule 2, item 2, table item 2 in
subsection 815-120(3)]

Note: for
simplicity, any references in the following examples to
‘table items’ refer to the table items in subsection
815-120(3). Further, an entity that is an Australian
resident, a resident trust estate or a partnership in which all of
the partners are ultimately Australian residents will be referred
to as a ‘resident entity’. Similarly, an entity
that is not a resident entity will be referred to as a
‘foreign resident entity’.

Application of the overseas requirement to
conditions that operate between two resident
entities

Example
3.1

Aus Co (an
Australian resident company) sells goods to Aus Trust (a resident
trust estate). The sale and purchase are each conducted
solely through the Australian business operations of Aus Co and Aus
Trust.

The overseas
requirement cannot be met under table item 1 because the conditions
do not operate at or through an overseas permanent establishment of
either Aus Co or Aus Trust.

Table item 2 is
not relevant for either Aus Co or Aus Trust because they are both
resident entities.

Example
3.2

Aus Co also sells
goods to Aus Part (a partnership in which all of the partners are
Australian residents). The sale is conducted through the
Australian business operations of Aus Co and the purchase is
conducted through an overseas permanent establishment of Aus
Part.

The overseas
requirement is met under table item 1 because the conditions
operate through an overseas permanent establishment of Aus
Part.

Example
3.3

Aus Part purchases
goods from Aus Trust. The sale and purchase are each
conducted through the overseas permanent establishments of Aus Part
and Aus Trust.

The overseas
requirement is met under table item 1 because the conditions
operate through an overseas permanent establishment of Aus
Part.

The overseas
requirement is also met under table item 1 because the conditions
operate through an overseas permanent establishment of Aus
Trust.

Application of the overseas requirement to
conditions that operate between a resident entity and a foreign
resident entity

Example
3.4

Aus Co sells goods
to For Co (a foreign resident company). The sale is conducted
solely through the Australian business operations of Aus Co
and the purchase is conducted solely through an Australian
permanent establishment of For Co.

The overseas
requirement cannot be met under table item 1 because the conditions
do not operate at or through an overseas permanent establishment of
Aus Co.

Similarly, the
overseas requirement cannot be met under table item 2 because the
conditions operate sorely through the Australian permanent
establishment of For Co.

Example
3.5

Aus Co sells goods
to For Trust (a non-resident trust estate). The sale is
conducted solely through the Australian business operations of
Aus Co and the purchase is conducted solely through the
overseas business operations of For Trust.

The overseas
requirement is met under table item 2 because the conditions do not
operate solely at or through an Australian permanent establishment
of For Trust.

Example
3.6

Aus Co purchases
goods from For Part (a partnership with three partners — two
of which are Australian residents and one of which is a foreign
resident). The purchase is conducted through an overseas
permanent establishment of Aust Co and the sale is conducted solely
through an Australian permanent establishment of For
Part.

The overseas
requirement is met under table item 1 because the conditions
operate through an overseas permanent establishment of Aus
Co.

Example
3.7

Aus Co purchases
goods from For Co. The purchase is conducted through an
overseas permanent establishment of Aust Co and the sale is
conducted solely through the overseas business operations of
For Co.

The overseas
requirement is met under table item 1 because the conditions
operate through an overseas permanent establishment of Aus
Co.

The overseas
requirement is also met under table item 2 because the conditions
do not operate solely at or through an Australian permanent
establishment of For Co.

Application of the overseas requirement to
conditions that operate between two foreign resident
entities

Example
3.8

For Co sells goods
to For Trust. The sale and purchase are each conducted solely
through the overseas business operations of For Co and For
Trust.

The overseas
requirement is met under table item 2 because the conditions do not
operate solely at or through an Australian permanent establishment
For Co.

The overseas
requirement is also met under table item 2 because the conditions
do not operate solely at or through an Australian permanent
establishment of For Trust.

Example
3.9

For Co sells goods
to For Part. The sale is conducted through the overseas
business operations of For Co and the purchase is conducted solely
through an Australian permanent establishment of For
Part.

The overseas
requirement is met under table item 2 because the conditions do not
operate solely at or through an Australian permanent establishment
of For Part.

Example
3.10

For Part purchases
goods from For Trust. The sale and purchase are each
conducted solely through the Australian permanent establishments of
For Part and For Trust.

The overseas
requirement cannot be met under table item 2 because the conditions
operate solely through an Australian permanent establishment of For
Part.

Similarly, the
overseas requirement cannot be met under table item 2 because the
conditions operate solely through an Australian permanent
establishment of For Trust.

Special rule for entities that are
dual-residents

3.65
An additional rule is also included in respect of entities that are
dual-residents of both Australia and a country with which Australia
has an international tax agreement containing a residence article
(a residence article is defined as Article 4 of the United Kingdom
convention or a comparable provision of another agreement).
If as the result of the residence article an entity is treated as a
resident of the other country under the agreement, they are deemed
not to be an
Australian resident for the purposes of meeting the overseas
requirement. In addition to applying to the entity to which
the overseas requirement directly applies, this rule also applies
to a trustee in determining whether a trust estate is a resident
trust estate, as well as the partners of a partnership in
determining whether all of the partners are Australian
residents. [Schedule 2, item 2,
subsections 815-120(4) and
(6) ]

3.66
The dual-resident rule is required because the treaty tie-breaking
rules in Australia’s international tax agreements only have
effect for the purpose of applying the agreement. This rule
aligns the application of Subdivision 815-B to that entity with its
treatment as a dual-resident under a treaty (which results in
Australia being limited to taxing the entity as though it were a
foreign resident).

3.67
There is no need for a rule to deem a dual-resident that is treated
as an Australian resident under an international tax agreement to
be an Australian resident because such entities are already
Australian residents. Similarly, the rule does not have any
operation in relation to treaties that do not apply to
dual-residents (such as the Chile and Turkey agreements), or
to non-treaty cases because in such circumstances an entity
continues to be taxed in Australia as an Australian resident.

Example
3.11

Aus Co purchases
goods from Dual Co. Dual Co is an Australian resident company
but is also a resident company of the UK. Under Article 4 of
the Australia-UK convention, Dual Co is treated as a UK
resident.

For the purposes
of the overseas requirement, Dual Co is not an Australian resident
and is instead taken to be a resident of the UK
only.

Example
3.12

Aus Co purchases
goods from Dual Part (a partnership with three partners — two
of which are Australian residents and one of which is both an
Australian resident and a resident of the UK).

For the purposes
of the overseas requirement, the dual-resident partner is not an
Australian resident and is instead taken to be a resident of the UK
only. This means that in meeting the overseas requirement,
Dual Part is taken to be a partnership in which not all of the
partners are Australian residents.

Conditions that operate in connection with an
area covered by an international tax sharing
treaty

3.68
The cross-border test will also be satisfied where the conditions
operate in connection with a business an entity carries on in an
area covered by an international tax sharing treaty.
[Schedule 2, item 2,
paragraph 815-120(3)(b)]

3.69 Although some parts of an
area covered by an international tax sharing treaty (for example
the Timor Sea Treaty) may still be in Australia, Australia’s
ability to impose tax upon income sourced in those areas (or deal
with expenditure in relation to such income) will be affected by
the terms of the agreement. As such, the cross-border test is
satisfied in relation to conditions that operate in connection with
a business carried on by an entity in an area covered by an
international tax sharing treaty, irrespective of the residency
status of that entity.

Application to parties that are not
related

3.70
In satisfying the cross-border test, it is not necessary for the
relevant entities to be associated. This approach is
consistent with Division 13 and ensures that this Subdivision
applies to any conditions that exist between entities that do not
operate on an arm’s length basis (such as collusive
arrangements between unrelated entities).

Conditions that are affected by arrangements
entered into by other entities

3.71
Although Subdivision 815-B can only apply to particular
actual conditions where the above requirements are satisfied in
respect of those conditions, it may be the case that other
arrangements or conditions are relevant in determining whether the
actual conditions are different from arm’s length conditions
or result in a tax advantage. These other arrangements need
not be covered by Subdivision 815-B.

3.72
Because arm’s length conditions are identified by
hypothesising what independent entities in comparable circumstances
dealing wholly independently would have done in the place of the
actual entities, interactions that each of the entities have with
other entities may be relevant where they impact upon the actual
conditions.

3.73
For example, if two entities were to enter into a loan arrangement
under which repayment of the loan was contingent upon one of the
entities achieving a certain profit position in an income year, the
question under Subdivision 815-B is whether independent entities
dealing wholly independently would have agreed to a repayment term
of that nature. If the borrower also had arrangements in
place with another entity that allowed that other entity to strip
profits from the borrower in order to keep it below the specified
repayment threshold, those profit shifting arrangements would
clearly be a relevant consideration in determining whether the loan
arrangement would have been entered into by independent
entities. This is the case irrespective of whether the profit
stripping arrangement is also covered by Subdivision 815-B.

3.74
It could also be the case that arrangements with other entities
appear to justify the existence of actual conditions that result in
a tax advantage relative to arm’s length conditions. In
such circumstances, the relevant question must still be whether
independent entities dealing wholly independently would have dealt
with one another in the way the actual entities did.

3.75
For example, if a resident entity were to purchase raw materials
from a foreign resident at an inflated price, the purchase price
would only be at arm’s length if independent entities dealing
wholly independently in comparable circumstances would have agreed
to the purchase price. This is the case irrespective of
whether the resident entity sells a product manufactured from those
materials to a third entity at an equally inflated price because,
having regard to its own economic interests, an independent entity
dealing with the seller of the raw materials would still have an
incentive to minimise their input costs.

What are the arm’s length
conditions?

3.76
The arm’s length conditions in relation to conditions that
operate between an entity and another entity are the conditions
that might be expected to operate between entities dealing wholly
independently with one another in comparable circumstances.
[Schedule 2, item 2,
subsection 815-125(1)]

3.77
Arm’s length conditions are the conditions that would have
operated between independent entities in place of the actual
conditions. The identification of arm’s length
conditions involves hypothesising what independent entities would
have done in the place of the actual entities. This process
requires the postulation of how independent entities in comparable
circumstances would have dealt with one another had they been
dealing at arm’s length. Cross-border intra-firm trade
in services and intangible assets has increased dramatically for
Australian entities over recent years. Determining the
arm’s length conditions in these situations is likely to go
beyond looking at the consideration provided in relation to a
single condition (such as the price of trading stock) or a discrete
element of the overall arrangement.

3.78
Similarly, there have been significant increases over recent years
in the volume and complexity of cross-border intra-firm financing
transactions involving various forms of debt and hybrid
securities. In the more complex cases involving these
financing facilities, determining the arm’s length conditions
could include factors that relate to an entity’s relative
financial strength, and how the market would perceive the
entity’s financial strength with explicit consideration given
to the fact that the entity is part of a larger multinational
group.

3.79
It may also be important to consider issues such as whether
independent entities operating in comparable circumstances would
have advanced loans with the same or similar characteristics,
provided various forms of credit support, sought to refinance at a
different market interest rate, issued shares or paid
dividends. The consideration of what price and under what
conditions those transactions would have occurred between
independent parties dealing wholly independently with one another
may also be necessary. Similar questions could also be asked
regarding royalties or licence payments (such as whether a sale and
licence back of a strategic intangible would happen between
independent parties), and could also include decisions that may
affect an entity’s liquidity, such as the time at which an
amount should be paid.

3.80
The term ‘comparable circumstances’ relates to the
profile of each of the hypothetical independent entities. By
requiring that the independent entities be in ‘comparable
circumstances’ to the actual entities, the nature of the
actual entities and the context within which they operate is
directly relevant in constructing the profile of the hypothetical
entities.

3.81
Although the profile of the independent entities must be comparable
to that of the actual entities, arm’s length conditions are
simply those conditions that might be expected to operate between
independent entities dealing wholly independently. The
definition of arm’s length conditions does not of itself
require that the arm’s length conditions reflect or conform
to actual conditions or the commercial or financial relations of
the entities.

Identifying arm’s length conditions:
the ‘basic rule’

3.82
In order to inform the characterisation of what the independent
entities would have done, Subdivision 815-B sets out a ‘basic
rule’ which generally applies in determining arm’s
length conditions. Under this rule, the identification of
arm’s length conditions must be based on the form and
substance of the commercial or financial relations in connection
with which the actual conditions operate. [Schedule 2, item 2,
subsection 815-130(1)]

3.83
This rule constrains the way in which the arm’s length
conditions must be identified. As a result, the form and the
substance of the commercial or financial relations that actually
existed between the entities (and which gave rise to the actual
conditions related to the arm’s length conditions that are
being identified), must be considered in the identification of the
arm’s length conditions.

3.84
The ‘form’ of commercial or financial relations
describes the prima
facie features or legal characteristics of the dealings
between entities. In contrast, the ‘substance’ of
the commercial or financial relations describes the economic
reality or essence of those dealings. The substance of
commercial or financial relations is determined by examining all
relevant facts and circumstances, including the economic and
commercial context of any arrangements entered into, its object and
effect from a practical and business point of view, the conduct of
the entities and the functions performed, assets used and risks
assumed by them.

The arm’s length condition is the most
appropriate and reliable condition

3.85
The identification of the arm’s length conditions involves
hypothesising what independent entities would have done in
comparable circumstances to the actual entities. As such, a
number of alternative conditions may be hypothesised as potentially
operating between independent entities.

3.86
In order to quantify a transfer pricing benefit and make the
consequent adjustment, Subdivision 815-B requires the selection of
the most appropriate and
reliable condition as the arm’s length
condition.

3.87
For example, where the identification of an arm’s length
condition requires the consideration of a range of values (as
opposed to a single value), the most appropriate and reliable point
within that range will determine the arm’s length condition.
Where a number of points within the range are equally
appropriate and reliable, any of those points may be selected.

Entities dealing wholly independently with one
another

3.88
Whether entities (associated or not) deal with each other in
accordance with the arm’s length principle is essentially a
question of fact. The relevant question for the purposes of
Subdivision 815-B is whether the conditions which operate between
the entities would make commercial sense if the entities were
dealing wholly independently with one another.

3.89
When considering whether parties have dealt with one another
independently, the question is whether they have acted as
independent parties would in comparable circumstances, so that the
outcome of the dealings is a matter of real bargaining:
Trustee for the Estate of the
late AW Furse No.
5 Will
Trust v Federal
Commissioner of Taxation (1990) 21 ATR 1123 at 1132.

3.90
The relationship between the parties is relevant but not
determinative. Thus, parties that are related to each other
may deal independently with one another and parties that are not
related to each other might not deal independently with one
another: Barnsdall v
Federal Commissioner of Taxation (1988) 81 ALR 173;
Furse 21 ATR 1123 at
1132; RAL and Ors and Federal
Commissioner of Taxation (2002) 50 ATR 1076 [at
45-51].

3.91
Examples of where parties that are unrelated to each other are not
dealing independently with one another include where:

â¢
one of the parties submits to the will or direction of the other,
perhaps to promote the interests of the other:
Granby v Federal Commissioner of
Taxation 129 ALR 503 at 507;

â¢
one party is indifferent to an outcome sought by the other party on
a particular aspect of their dealings: Collis v Federal Commissioner of
Taxation (1996) 33 ATR 438 at 443; or

â¢
the parties collude, or act in concert, to achieve an ulterior
purpose or result: Granby 129 ALR 503 at 507.

Identifying arm’s length conditions:
exceptions to the ‘basic
rule’

3.92
There are three exceptions to the ‘basic rule’ for
identifying arm’s length conditions. Where these
exceptions apply, actual commercial or financial relations in
connection with which the actual conditions operate are disregarded
for the purposes of identifying arm’s length
conditions. Specific rules for each exception then provide
the alternative means of identifying arm’s length
conditions. As with the basic rule, the exceptions continue
to constrain the way in which the arm’s length conditions
must be identified.

3.93
In determining whether the exceptions apply, as well as identifying
the arm's length conditions under one of the exceptions, rules
related to the comparability of circumstances remain
relevant. [Schedule 2, item 2, subsections
815 130(5)]

3.94
The exceptions to the basic rule are intended to be consistent with
the ‘exceptional circumstances’ discussed in the OECD
Guidelines in the context of non-recognition and alternative
characterisation of certain arrangements or transactions (for
example under Chapters I and IX of the OECD Guidelines).
Given that the OECD Guidelines are prescribed as relevant guidance
material under the guidance provision in Subdivision 815-B,
the identification of arm’s length conditions under one of
the exceptions must be done that best achieves consistency with any
aspects of the Guidelines that are relevant.

3.95
The first exception is based on the approach taken under the OECD
Guidelines in relation to economic substance (see for example
paragraphs 1.65, 9.169 and 9.183 of the OECD
Guidelines). In this regard paragraph 9.183 of the OECD
Guidelines states:

‘Under the
first circumstance of paragraph 1.65, where the economic substance
of a transaction differs from its form, the tax administration may
disregard the parties' characterisation of the transaction and
re-characterise it in accordance with its
substance.’

3.96
The second and third exceptions are based on the approach taken
under the OECD Guidelines in relation to the non-recognition and
alternative characterisation of certain arrangements (see for
example paragraphs 1.65, 1.66, 9.61, 9.175, 9.169 and 9.185 of the
OECD Guidelines). In this regard, paragraph 1.66 of the OECD
Guidelines states:

‘Article 9
would thus allow an adjustment of conditions to reflect those which
the parties would have attained had the transaction been structured
in accordance with the economic and commercial reality of parties
dealing at arm’s length.’

The form of the commercial or financial
relations differs from the substance

3.97
In cases where the form and substance of the actual commercial or
financial relations of the entities differ, the form is disregarded
to the extent of the inconsistency with the substance.
[Schedule 2, item 2,
subsection 815-130(2)]

3.98
The arm’s length principle is fundamentally concerned with
ensuring that entities are appropriately rewarded for their
economic contributions. Although in many cases, the substance
of the commercial or financial relations will be identical to the
legal form, where this is not the case the identification of
arm’s length conditions must be based on the substance of the
entities’ commercial or financial relations. Although
the effect of this rule is that certain aspects of the commercial
or financial relations are disregarded, the identification of
arm’s length conditions still relates to actual commercial or
financial relations that exist between the entities.

Independent entities would have entered into
different commercial or financial relations

3.99
In cases where independent entities dealing wholly independently
with one another in comparable circumstances would not have entered
into the actual commercial or financial relations, the
identification of arm’s length conditions is based on the
commercial or financial relations that independent entities would
have instead entered into. [Schedule 2, item 2,
subsection 815-130(3)]

3.100
This exception only applies where, having regard to their own
economic interests, independent entities dealing wholly
independently would not have entered into the actual commercial or
financial relations, but would have instead entered into
alternative commercial or financial relations that differ in
substance from the actual commercial or financial
relations.

3.101
As each element of this test must be positively satisfied, it is
not of itself sufficient to propose that independent entities might
have dealt with one another in an alternative manner.
Moreover, the mere fact that actual independent entities have not
been observed to have dealt with one another in a particular way
(or that information on such independent dealings is not available)
will not necessarily mean that independent entities would not have
entered into the commercial or financial relations that the
entities actually did. The relevant question is instead
whether independent entities behaving in a commercially rational
manner and acting in their own best commercial and economic
interests would have dealt with one another in the same way, given
the options that are realistically available to them. Without
detracting from the relevance of actually observed dealings,
nothing prevents each aspect of the test from being established
hypothetically.

3.102
The requirement that independent entities ‘would’ have
done something different to the actual entities imposes a higher
standard of proof than simply demonstrating that independent
entities ‘might’ or ‘might be expected to’
have entered into alternative commercial or financial
relations.

3.103
This standard is intended to reduce the number of possible
alternatives that can be hypothesised under the exception. In
the event that more than one alternative set of commercial or
financial relations would have been entered into by independent
entities (for example, because the overall effect of each
alternative is similar enough that independent entities would be
indifferent about which one operated), the substituted commercial
or financial arrangements under this exception should comport as
closely as possible with the facts and economic substance of what
actually occurred. This approach is consistent with both the
OECD Guidelines (see for example paragraph 9.187 of the OECD
Guidelines) and the requirement in the exception that in the course
of identifying arm’s length conditions, the independent
entities must be in comparable circumstances to the actual
entities.

Independent entities would not have entered into
any commercial or financial relations

3.104
In cases where independent entities dealing wholly independently
with one another in comparable circumstances would not have entered
into any commercial or financial relations, the identification of
arm’s length conditions is based on the assumption that no
commercial or financial relations existed. [Schedule 2, item 2,
subsection 815-130(4)]

3.105
This exception will only apply where independent entities dealing
wholly independently would not have entered into the actual
commercial or financial relations, or any other commercial or
financial relations whatsoever. The effect of this exclusion
is that the actual commercial or financial relations are
disregarded for the purposes of identifying arm’s length
conditions. In such cases, the actual conditions connected
with the commercial or financial relations are likely to be
disregarded, and the arm’s length condition is that nothing
would have occurred.

3.106
Any arm’s length conditions that are identified under this
exception are still subject to the general transfer pricing benefit
requirements set out under section 815-120, meaning that this
exception does not apply if disregarding the commercial or
financial relations would result in the entity obtaining an
Australian tax advantage (for example, an actual payment to the
entity could not be disregarded under this exception). As
such, application of this exclusion is limited to disregarding
positive actions of an entity that give rise to a transfer pricing
benefit. One example of this would be where the actual
commercial or financial relations result in an expense being borne
by an entity that would simply not have been borne by an
independent entity in comparable circumstances. In such
instances, the non-recognition of the expense would result in the
entity not being able to claim a deduction.

Selecting the method or combination of methods
to determine the arm’s length
conditions

3.107
Transfer pricing methods seek to determine what the arm’s
length conditions would be if the parties involved were dealing
wholly independently with one another. An entity required to
identify arm’s length conditions under Subdivision 815-B must
use the method or methods that produces the most appropriate and
reliable assessment of the conditions having regard to:

â¢
the respective strengths and weaknesses of the possible transfer
pricing methods;

â¢
the circumstances, including the functions performed, the assets
used and the risks borne by the entities;

â¢
the availability of reliable information required to apply a
particular method; and

â¢
the degree of comparability between the actual circumstances and
the comparable circumstances, including the reliability of any
adjustments to eliminate the effect of material differences between
those circumstances.

[Schedule 2, item
2,
subsection 815-125(2)]

3.108
The method must be capable of practicable application and produce
an arm’s length outcome that is a reasonable estimate of what
would have been expected if the dealings had been undertaken
between independent entities dealing wholly independently with one
another.

Which methods are
relevant?

3.109
The OECD Guidelines provide a framework for the application of the
arm's length principle.

3.110
Pursuant to the guidance rules in Subdivision 815-B, entities must
have regard to the OECD Guidelines in identifying arm’s
length conditions.

3.111
Although the various methods currently outlined in the OECD
Guidelines are explained in the following paragraphs, these methods
are not the only methods that may be used. Consistent with
the OECD Guidelines, where an alternative method (or combination of
methods) gives a more appropriate arm’s length outcome, that
alternate method (or combination of methods) may be used.

Comparable uncontrolled price
method

3.112
The comparable uncontrolled price (CUP) method compares the price
actually charged for property or services that have been
transferred with the price that would be charged for materially the
same property or services by the same supplier in a comparable
dealing with an independent party or by a comparable independent
entity dealing wholly independently with another entity in
comparable circumstances.

Cost plus method

3.113
The cost plus method provides an estimate of an independent margin
by adding an appropriate cost plus mark-up to the supplier’s
costs. The profit mark-up is determined by reference to the
cost-plus mark-up earned by the same supplier in comparable
dealings with independent parties or by independent entities
dealing wholly independently with each other in comparable
circumstances.

Resale price method

3.114
The resale price method estimates an independent price for property
or services by taking the price at which the product is sold to or
by independent entities and reducing it by an independent resale
price margin. The margin would be determined by reference to
the resale price margins earned by the same supplier in comparable
dealings with independent parties or by independent entities
dealing wholly independently with each other in comparable
circumstances.

Transactional Net Margin
Method

3.115
The transactional net margin method (TNMM) compares the net profit
margin that the taxpayer has achieved with that which independent
parties dealing wholly independently in relation to a comparable
transaction or dealings would have achieved.

3.116
Comparisons at the net profit level can be made on a single
transaction or in relation to an aggregation of dealings between
the taxpayer and one or more other entities.

3.117
The TNMM examines the net profit margin relative to an appropriate
base (for example, costs, sales, assets) that a taxpayer realises
from an activity or transaction.

Profit split method

3.118
The profit split method identifies the combined profit of two or
more enterprises and then splits those profits between the
enterprises on an economically valid basis that approximates the
division of profits that independent entities would have expected
to realise had the arrangements existed between parties dealing
wholly independently.

3.119
The profit split method may be appropriate where different
activities undertaken by the entities make unique and valuable
contributions. In these cases, it may not be practical or
feasible to assess arm’s length outcomes with reference to a
specific comparable.

Equally appropriate
methods

3.120
Consistent with the OECD Guidelines, where it is considered that
more than one method can be applied in an equally reliable manner,
the more direct method should be preferred. For example,
where a transaction based method and a profit based method are
equally reliable (taking into account the factors provided for in
subsection 815-125(2)), the transaction based method
should be preferred.

Comparability of
circumstances

3.121
One of the factors in selecting and applying a method is the
degree of
comparability between the actual circumstances and any
circumstances being compared.

What is meant by the term
‘comparable’?

3.122
For circumstances to be comparable, none of the differences (if
any) between the situations being compared should be capable of
materially affecting a condition that is relevant to the
method. [Schedule 2, item 2, paragraph
815-125(4)(a)]

3.123
Where differences exist, a situation may be considered comparable
if reasonably accurate adjustments can be made to eliminate the
effects of the difference on a condition that is relevant to the
method. [Schedule 2, item 2, paragraph
815-125(4)(b)]

Example
3.13 : Comparability adjustments

Most of Aus
Co’s dealings are with wholly independent enterprises.
Aus Co does however undertake limited dealings with a
non-arm’s length party that operates in the same market,
undertakes comparable commercial roles, does not undertake a
commercial strategy, is of comparable market importance and takes
possession of comparable amounts of production inputs as the
independent enterprises with which Aus Co deals. However, the
dealings between Aus Co and the non-arm’s length party are on
different freight terms to those with other independent
enterprises. The non-arm’s length dealing, while not
being completely comparable, is capable of being adjusted for
freight terms such that the circumstances are comparable, to
achieve comparability between the conditions of the commercial or
financial relations of the independent and non-arm’s length
arrangements.

3.124
Where reliable comparability adjustments cannot be made, this may
indicate that another method should be used, which relies on
different points of comparison.

3.125
In determining the degree of comparability, including any
adjustments that may be necessary, consideration must be given to
the range of options that would be realistically available to an
independent enterprise in comparable circumstances. That is,
consideration needs to be given to what an independent enterprise
would consider in terms of the options available to it and whether
the options would significantly affect the value of an
arrangement.

What factors must be taken into account in
determining comparability?

3.126
In identifying comparable circumstances, regard must be had to all
relevant factors including but not limited to the following:

â¢
the functions performed, assets used and risks borne by the
entities;

â¢
the characteristics of any property or services transferred;

â¢
the terms of any relevant contracts between the entities;

â¢
the economic circumstances; and

â¢
the business strategies of the entities.

[Schedule 2, item
2,
subsection 815-125(3)]

How do the OECD Guidelines describe these
factors?

3.127
Below is a selected discussion of the factors as presented by the
OECD Guidance material. However, the entire text of the OECD
Guidance material should be taken into account when determining
whether the circumstances are of a sufficient level of
comparability.

Functional analysis

3.128
In general, the level of compensation that passes between entities
should reflect the functions that each entity performs (taking into
account assets used and risks assumed). Therefore in
determining whether certain arrangements or entities are
comparable, a functional analysis is required. Such a
comparison must seek to identify and compare the commercially
significant activities and responsibilities undertaken, assets used
and risks assumed by the parties.

3.129
The types of functions that may be relevant include those relating
to design, manufacture, assembly, research and development,
servicing, purchasing, distribution, marketing, advertising,
transportation, financing and management. It is important to
consider the assets used or intended to be used and the condition
and value of those assets. Assets might include, but would
not be limited to, plant and equipment, valuable intellectual
property, and financial assets.

3.130
The risks assumed by different parties are an important feature of
a functional analysis. Generally, in an open market, the
assumption of increased risk would also be compensated by an
increase in the expected return.

3.131
The types of risks that might be considered would include but not
be limited to market risks such as fluctuations in input costs and
output prices, risks associated with investment in and use of
property, plant and equipment, risks of the success or failure of
investment in research and development; financial risks, credit
risks and so forth.

3.132
The functions carried out (taking into account the assets used and
risks assumed) determine to some extent the allocation of risks
between the parties. In considering this allocation it is
important that the risks allocated on a contractual basis match the
economic substance of the arrangements. In this regard, the
parties’ conduct should generally be taken as the best
evidence concerning the true allocation of risk. Furthermore,
in considering the economic substance of a purported risk
allocation, it generally makes sense for parties to be allocated a
greater share of those risks over which they have relatively more
control — arm’s length parties would generally not be
willing to assume risks over which another party has significantly
more control.

Characteristics of the property or
services

3.133
Any differences in the specific characteristics of the property or
services that are relevant to the arrangements in place between the
relevant entities and those that are potentially comparable need to
be carefully considered. Such differences would often
account, at least in part, for differences in value.

3.134
In general, the requirement for comparability of property or
services is the strictest when using the comparable uncontrolled
price method, as any material difference in the characteristics of
property or services can have an effect on the price and would
require an appropriate adjustment to be considered. By
contrast, the remaining methods, which look at gross profit
margins, mark-up on costs or other profit-based indicators, are
generally less sensitive to such differences.

3.135
In considering the specific characteristics of the property or
services transferred, it is important to consider such things as
the physical features of the property, its quality and reliability,
and the availability and volume of supply.

Contractual terms

3.136
Contractual terms often shed light expressly or implicitly on the
nature of arrangements. There may be written documentation in
place of, or in addition to contractual documents that add to the
overall picture of how responsibilities, risks and benefits are to
be divided between parties.

3.137
Where no written documents exist, the contractual relationship
between parties must be deduced from their conduct and the economic
principles that generally govern relationships between independent
parties.

3.138
When parties are dealing wholly independently their separate
interests will usually motivate them to hold the other to the
contractual terms unless it is in their mutual interests to modify
them. When parties are not dealing wholly independently the
same incentives may not be present and it is important to establish
whether the economic substance of arrangements matches the
contractual terms.

Economic circumstances

3.139
Prices and other financial indicators may vary across different
markets even where relevant transfers are for the same property or
services. Therefore comparability requires that the relevant
markets are comparable, if indeed they are not in the same
market. In identifying the relevant market or markets regard
should be had, amongst other things, to:

â¢ geographic
location;

â¢ the size of the
markets;

â¢ the extent of
competition in the markets and the relative competitive positions
of the buyers and sellers;

â¢ the availability of
substitute goods and services;

â¢ the levels of supply
and demand;

â¢ consumer purchasing
power;

â¢ the nature and extent
of government regulation;

â¢ costs of
production;

â¢ transport
costs;

â¢ the level of the
market; and

â¢ the date and time of
transactions.

Business strategy

3.140
Business strategies must also be examined in determining
comparability for transfer pricing purposes. The business
strategies employed by an entity may materially impact on the
conditions that operate in the commercial or financial relations
between entities. The business strategies adopted may
influence the degree of innovation and new product development,
risk diversification and aversion; and would take into account the
enterprise’s assessment of future changes in the commercial
environment.

3.141
Business strategies could also include market penetration
schemes. An enterprise seeking to penetrate a market to
increase market share might temporarily charge a price for its
product or services that is lower than the price charged by
otherwise comparable products in the same market.
Furthermore, an enterprise seeking to enter a new market or expand
(or defend) its market share might temporarily incur higher costs
(for example, due to start-up costs or increased marketing
efforts).

3.142
Generally a market penetration scheme results in lower profits as
it is being prosecuted, with an expectation of higher profits in
the future. When evaluating purported business strategies,
factors such as the actual conduct of the parties, the nature of
the relationships between them, and whether there is a plausible
expectation that the strategies will succeed (within a period of
time that would be acceptable in an arm’s length arrangement)
are likely to be relevant.

How does the arm’s length principle apply
when the thin capitalisation rules also apply to an entity for the
relevant period?

3.143
Where Division 820 applies to an entity for an income year and the
entity has worked out elements of its tax position under arm's
length conditions that relate to its debt deductions, a special
rule modifies the way in which Subdivision 815-B applies to the
entity. [Schedule 2, item 2, subsection
815-140(1)]

3.144
The rule preserves the role of Division 820 in respect of its
application to an entity’s amount of debt. If under the
arm’s length conditions, working out an entity’s debt
deductions involves applying a rate to a debt interest, the rule
requires the rate to be worked out as if the arm’s length
conditions had operated. However, this rate is applied to the
debt interest the entity actually issued instead of the debt
interest that would have been issued had the arm’s length
conditions operated (in the event that there is a difference
between the interests). [Schedule 2, item 2,
subsection 815-140(2)]

3.145
The rule maintains the administrative approach under Taxation
Ruling TR 2010/7, which was confirmed in Subdivision 815-A.

3.146
To the extent that an entity’s debt deductions are worked out
by applying a rate to a debt interest (such as by applying a rate
of interest to a loan amount, or applying a rate to the amount of
debt covered by a guarantee) the identification of arm’s
length conditions in respect of those debt deductions is modified
so that only the rate may be adjusted. As such, Subdivision
815-B allows the rate to be adjusted to an arm’s length rate,
but that rate must be applied to the debt interest actually issued
(and still on issue from time to time). This ensures that
Subdivision 815-B does not prevent the operation of the thin
capitalisation rules.

3.147
Debt deductions (as defined in section 820-40) include any costs
directly incurred in obtaining or maintaining a debt interest, for
example interest or amounts in the nature of interest, guarantee
fees, line fees and discounts on commercial paper.

3.148
The interaction of this Subdivision with Division 820 operates as
follows:

â¢
First, to the extent relevant, the arm’s length rate applying
to a debt interest is determined in accordance with the normal
rules contained in section 815-115. In doing so, it is
necessary to consider the conditions operating between the relevant
entity and other entities in relation to the commercial or
financial relations that exist between them. The arm’s
length rate may need to be determined by having regard to the
conditions which could be expected to operate between entities
dealing wholly independently with each other. For example, in
some exceptional cases (as provided by the relevant OECD guidance
material), it may be appropriate to determine the arm’s
length rate having regard to the amount of debt the entity is
likely to have had, had the conditions operating between it and its
associate(s) been consistent with what they would have been if the
entities had been independent of each other. Alternatively,
it may be possible to determine an arm’s length rate,
directly or indirectly, by some other means without having to
determine an arm’s length amount of debt. Whether an
entity’s amount of debt meets the safe harbours provided for
the purposes of Division 820 is not relevant for this first
step.

â¢
Secondly, the arm’s length rate for a particular debt
interest is applied to the actual amount of debt for that debt
interest. The entity’s remaining debt deduction after
the arm’s length rate of interest has been applied then
becomes the relevant debt deduction for the purposes of Division
820.

â¢
Finally, and after the consideration of any other relevant parts of
the ITAA 1936 and ITAA 1997, Division 820 may reduce an
entity’s otherwise allowable debt deductions if the
entity’s adjusted average debt exceeds its maximum allowable
debt.

3.149
Similar to Subdivision 815-A, the following examples
illustrate the interaction of Subdivision 815-B and Division
820. They are intended to illustrate the respective fields of
operation of Subdivision 815-B and the thin capitalisation rules
and are not intended to suggest that a particular method for
pricing debt must be applied to the circumstances of a particular
case. Nor are the examples intended to preclude the use of
other methods that produce an arm’s length outcome.

Aus Co is an
Australian resident subsidiary company of For Co, a resident of the
UK. Aus Co is an ‘inward investment vehicle
(general)’ for the purposes of Subdivision
820-C.

For an income
year, Aus Co has:

â¢
a ‘safe harbour debt amount’, determined in accordance
with section 820-195 of $375 million; and

â¢
‘adjusted average debt’ determined in accordance with
subsection 820-185(3) of $400 million, of which $200 million
is borrowed from For Co at an interest rate of 15 per cent, and
$200 million from an independent lender at an interest rate of
10 per cent.

Aus Co’s
only debt deductions are for the interest incurred at a rate of 15
per cent on its $200 million related party debt, and 10 per cent on
its $200 million debt from the independent lender, meaning that it
has $50 million of debt deductions for the income
year.

Aus Co needs to
consider whether they would receive a transfer pricing benefit as a
result of actual conditions that it would not receive if
arm’s length conditions instead operated. In doing so,
Aus Co has regard to the arm’s length rate in relation to the
debt interest (that is, the arm’s length interest rate),
applied to the actual amount of the related party
debt.

Assume that the
loan from the independent lender is sufficiently similar to the
loan from For Co. Also assume that the circumstances in which
each amount of debt funding was provided do not present material
differences that would affect the rate applicable to the debt
interest or Aus Co’s ability to obtain $400 million in debt
funding (that is, the independent loan is directly comparable to
the related party loan). As a result, using a comparable
uncontrolled price is the most appropriate method for determining
the arm’s length rate. In these circumstances it is
commercially realistic for Aus Co to determine that the arm’s
length interest rate is 10 per cent. In this case, Aus Co
gets a transfer pricing benefit of $10 million (being the
difference between an arm’s length rate of 10 per cent
applied to the debt interest arising from the loan from For Co
($200 million) and the actual interest rate of 15 per cent on
the debt interest).

Assume the facts
and circumstances are the same as in Example 3.14, except that Aus
Co has $300 million of debt ($150 million from For Co and $150
million from an independent lender) and $100 million of equity,
producing a safe harbour debt amount for Division 820 purposes of
$300 million. The interest rate on Aus Co’s debt to For
Co is 15 per cent, so that, before applying Subdivision 815-B and
Division 820, Aus Co has total debt deductions of $37.5
million.

As was the case in
Example 3.14, Aus Co determines that an arm’s length interest
rate of 10 per cent is to be applied to the debt interest from For
Co. As such, Aus Co gets a transfer pricing benefit of
$7.5 million (being the difference between the arm’s
length rate of 10 per cent applied to the debt interest
from For Co ($150 million) and the actual interest rate of 15 per
cent on the debt interest).

Assume the facts
and circumstances are the same as in Example 3.15, except that the
entire $300 million of debt is borrowed from For Co at an interest
rate of 15 per cent. Aus Co’s debt deductions for the
interest incurred on its $300 million debt total $45 million for
the income year.

Unlike the
previous examples, there is no internal comparable uncontrolled
price that provides an arm's length rate. As such, Aus Co
determines the arm’s length rate of interest for the loan
having regard to available data of market reference rates and the
credit standing that the capital markets would be likely to give
Aus Co. Aus Co determines that its credit standing would
allow it to borrow $250 million from independent
lenders. Having regard to the information available, the
closest commercially realistic arm's length scenario at which a
loan might reasonably be expected to exist between independent
parties dealing wholly independently with one another is a loan of
$250 million at 10 per cent.

In this case the
amount of the transfer pricing benefit is determined by reference
to an amount less than the actual amount of the debt interest
(being an arm’s length amount). The fact that Aus
Co’s debt amount is less than its safe harbour debt amount
for Division 820 purposes is not relevant to determining the amount
of the transfer pricing benefit. Alternatively structured
arrangements do not need to be considered in this
case.

Aus Co’s
transfer pricing benefit is $15 million (as required under
subsection 815-135(2)). This is worked out by applying the
10 per cent arm’s length interest rate to Aus
Co’s actual debt amount ($300 million), and comparing this to
Aus Co’s actual debt deductions of $45
million.

Consequential Adjustments

3.150
The application of Subdivision 815-B to determine the tax position
of an entity could potentially impact the tax result of another
entity, or of the same entity, in the same or a different income
year. Accordingly, the Commissioner may make a consequential
adjustment to ensure that taxpayers are subject to an appropriate
amount of tax in Australia.

3.151
The Commissioner may make a determination in relation to a
disadvantaged entity if:

â¢
an entity is required by section 815-115 to work out its tax
outcome under arm’s length conditions;

â¢
the disadvantaged entity would have had a more favourable tax
result if the arm’s length conditions had operated: that is,
the disadvantaged entity would have been expected to have a smaller
taxable income, a greater loss of a particular sort, a greater tax
offset, or a smaller amount of withholding tax payable in respect
of interest or royalties had the arm’s length conditions
operated; and

â¢
the Commissioner considers that it is fair and reasonable that the
consequential adjustment should be made.

[Schedule 2, item
2,
subsection 815-145(1)]

3.152
The disadvantaged entity may be the entity to which
Subdivision 815-B applied, or another entity.

3.153
In determining whether the application of Subdivision 815-B has
resulted in an entity being disadvantaged, the Commissioner must
consider whether a similar calculation to that which is performed
under section 815-115 is required. That is, the disadvantaged
entity must be able to show that it would have had a smaller
taxable income, a greater loss of a particular sort, greater tax
offsets or a smaller amount of withholding tax payable. This
involves a comparison between the actual amounts and the
arm’s length amounts.

How are consequential adjustments be
made?

3.154
Where the Commissioner considers that it is fair and reasonable to
make an adjustment to the tax position of the disadvantaged entity,
the Commissioner may make a determination in order to:

â¢
decrease the entity’s taxable income for an income year;

â¢
increase the entity’s loss of a particular sort for an income
year;

â¢
increase the entity’s tax offsets for an income year; or

â¢
decrease the entity’s withholding tax payable in respect of
interest or royalties.

[Schedule 2, item
2,
subsection 815-145(2)]

3.155
The Commissioner may also take actions necessary to give effect to
the determination made under this section. For example, the
Commissioner may remit the relevant tax paid by an entity subject
to a specific determination under this section, notwithstanding the
absence of a specific provision in the law to that effect.
[Schedule 2, item 2,
subsection 815-145(3)]

3.156
The Commissioner must provide a copy of the determination to the
disadvantaged entity. However a failure to provide a copy of
the determination does not affect the validity of the
determination. [Schedule 2, item 2,
subsections 815-145(4) and
(5)]

3.157
Determinations relating to different income years may be included
in the same document. The Commissioner may include all or any
determinations in relation to a particular entity, including
different kinds of determinations, within the same document.
[Schedule 2, item 2, subsection
815-145(6)]

3.158 An entity may make a request
to the Commissioner to make a determination in relation to a
consequential adjustment. The Commissioner must decide
whether to grant the request, and give the entity notice of his
decision. If the entity is dissatisfied with the decision,
the entity may object against that decision in the manner that is
set out in Part IVC of the Taxation Administration Act
1953 . [Schedule 2, item 2,
subsections 815-145(7) and
(8)]

Aus Co is an
Australian resident company that has paid interest on a loan to a
foreign resident related party. In accordance with the
arm’s length principle, Aus Co determines that the interest
is excessive and, in order to apply the arm’s length
assumption, works out that it has received a transfer pricing
benefit under section 815-120. Aus Co has
therefore applied paragraph 815-115(2)(a), and increased
its taxable income by reducing its allowable
deductions.

The interest
payment to the foreign resident associated entity was subject to
interest withholding tax. Aus Co applies to the Commissioner
under subsection 815-145(7) to make a consequential
adjustment. The Commissioner determines that it is fair and
reasonable to make a consequential adjustment in respect of the
interest paid to the foreign company in excess of the arm’s
length amount that was subject to withholding
tax.

To give effect to
the determination the Commissioner refunds the relevant amount of
interest withholding tax to the foreign resident associated
entity.

Time limit for amending
assessments

3.159
Under Division 13 and Subdivision 815-A, the Commissioner had
an unlimited period in which to make or amend an assessment in
relation to a transfer pricing adjustment.

3.160 Under Subdivision
815-B, the Commissioner is subject to a time limit for
amending assessments. A transfer pricing adjustment to the
tax position of an entity as a result of the application of
Subdivision 815-B must be made within seven years of the day on
which the Commissioner gives notice of the assessment to the
entity. [Schedule 2, item 2,
subsection 815-150(2)]

3.161 This time limit does not
apply to the Commissioner’s ability to ascertain additional
amounts of withholding tax payable under Subdivision 815-B.
This is because, pursuant to subsection 128C(6) of the ITAA 1936,
any ascertainment of withholding tax does not constitute an
assessment. A time limit in respect of adjustments to
withholding tax under Subdivision 815-B is not included because no
such time limit exists generally in respect of withholding
tax.

3.162 There is no time limit for
the Commissioner to make a consequential amendment under section
815-145. This is consistent with the unlimited time period
that was available for making consequential adjustments under
Division 13. [Schedule 2, item 2,
subsection 815-150(2)]

Subdivision 815-C

What is the object of Subdivision
815-C?

4.1
The object of Subdivision 815-C is to ensure that the
amount brought to tax in Australia by entities operating at or
through permanent establishments is not less than it would be if
the permanent establishment (PE) were a distinct and separate
entity engaged in the same or comparable activities under the same
or comparable circumstances, but dealing wholly independently with
the entity of which it is a part. [Schedule 2, item 2,
section 815-205]

4.2
In recent years the Organisation for Economic Cooperation and
Development (OECD) has revised its approach to the attribution of
business profits to PEs. The authorised OECD approach now
reflects the functionally separate entity approach. The
Government has yet to determine whether it will change its tax
treaty practice to adopt the functionally separate entity approach
and as such Subdivision 815-C reflects the approach to
the attribution of profits to PEs that is currently incorporated
into Australia’s tax treaties (the relevant business activity
approach).

How does Subdivision 815-C interact with the
rest of the Act?

4.3
Consistent with Subdivision 815-B, Subdivision 815-C takes
precedence over other provisions of the Income Tax Assessment Act 1936
(ITAA 1936) and the Income Tax
Assessment Act 1997 (ITAA 1997) unless a limitation to
its operation is explicitly provided within the Subdivision.
[Schedule 2, item 2,
subsection 815-210(1)]

4.4
This means that to the extent that an entity is liable to a
different tax result under Subdivision 815-C because arm’s
length profits are taken to have been attributed to a PE of the
entity, Subdivision 815-C must be applied in working out the
entity’s Australian tax liability.

4.5
This priority rule does not however overcome the effect of
subsection 4(2) of the International Tax Agreements Act
1953 (ITAA 1953) (referred to at paragraphs 2.37
and 2.38 above). This is because the priority rule in
Subdivision 815-C applies to provisions of the ITAA 1936 and ITAA
1997 (the Assessment Acts), whereas subsection 4(2) applies to
the extent of an inconsistency between the ITAA 1953 and the
Assessment Acts.

4.6
Subdivision 815-C does not limit the application of Division 820
(which is about thin capitalisation) in reducing, or further
reducing, an entity’s debt deductions. [Schedule 2, item 2,
subsection 815-210(2)]

4.7
This rule preserves the role of Division 820 in its application to
an entity’s amount of debt. In addition to this rule,
Subdivision 815-B contains other special rules that apply in
working out an entity’s transfer pricing adjustment where
Division 820 also applies (the rule in Subdivision 815-B may be
relevant in determining the arm’s length profits of a
PE).

4.8
A specific rule is not required to deal with the interaction
between Subdivision 815-C and the thin capitalisation rules because
Subdivision 815-B applies in identifying arm’s length profits
for a PE. In this process the PE is treated, under certain
constraints, as an entity. The provisions of Subdivision
815-B, including the thin capitalisation interaction rule, then
apply to determine the arm’s length conditions for the PE to
the extent they are relevant.

4.9
Subdivision 815-C does not apply in respect of a branch that is
taken not to be a permanent establishment under Part IIIB of
the ITAA 1936. [Schedule 2, item 2,
subsection 815-210(3)]

4.10
Part IIIB applies the functionally separate entity approach in
respect of the attribution of income and expenditure to the
Australian PEs of foreign banks. Consistent with the
interaction between Part IIIB and former Division 13 of the ITAA
1936 (Division 13), Subdivision 815-C does not apply to PEs dealt
with under Part IIIB.

Working out an entity’s tax
position

4.11
Subdivision 815-C applies where an entity gets a transfer pricing
benefit in an income year from the attribution of profits to a PE
of the entity. In such cases, the actual amount of profits
are taken not to have been attributed to the PE, and instead the
arm’s length profits are taken to have been attributed to the
PE for the purposes of working out the amount to which the transfer
pricing benefit relates. [Schedule 2, item 2,
subsection 815-215(1)]

4.12
These amounts can be the amount of an entity’s taxable
income, a loss of a particular sort or tax offsets for an income
year. [Schedule 2, item 2,
subsection 815-215(2)]

4.13
In contrast to Subdivision 815-B, Subdivision 815-C does not apply
in respect of amounts of withholding tax payable. This is
because Subdivision 815-C applies in respect of the
intra-entity allocation of income and expenses and as such its
effect does not have any implications for withholding
tax.

4.14
A tax loss, film loss or net capital loss are all identified by
subsection 701-1(4) as a loss of a particular sort.

4.15
Subdivision 815-C ensures that the attribution of profits between a
PE and other parts of the entity reflect the contribution made by
the operations of those parts of the entity (consistent with the
entity’s actual income and expenses). After the
arm’s length profits are attributed to the PE of the entity,
whether and how those profits affect the entity’s Australian
tax result and any elements in the calculation of its tax result
under the relevant sections of the tax law must be
considered.

4.16
As with Subdivision 815-B, Subdivision 815-C does not contain
an explicit rule requiring individual amounts to be
specified. A rule of this kind is not necessary because under
Subdivision 815-C an entity is required to work out its taxable income, loss of
a particular sort or tax offsets on the basis that arm’s
length profits had been attributed to its PE. This process is
different from simply making an overall adjustment to these amounts
and by definition requires that the entity identify and value the
various items that are relevant in determining the aggregated
amounts.

Guidance material

4.17
In establishing the effect that Subdivision 815-C has in respect of
an entity, the identification of arm’s length profits and
arm’s length conditions (under the assumption that the PE is
a distinct and separate entity) must be done in a way that best
ensures consistency with certain guidance material.
[Schedule 2, item 2, subsection
815-235(1)]

4.18
This guidance material is:

â¢
the Model Tax Convention on Income and on Capital, and its
Commentaries, as adopted by the Council of the OECD and last
amended on 22 July 2010, to the extent that document extracts the
text of Article 7 and its Commentary as they read before 22 July
2010;

â¢
the guidance documents specified by Subdivision 815-B which
currently include the OECD
Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations as approved by the Council of the OECD
and last amended on 22 July 2010 (OECD Guidelines); and

â¢
any other documents, or part(s) of a document, prescribed by the
regulations for the purposes of either Subdivision 815-C or
Subdivision 815-B.

4.19
Requiring consistent interpretation with the OECD Guidelines (where
relevant) does not imply that the legislation is adopting the
functionally separate entity approach to the attribution of profits
to PEs. As stated earlier, the Government has yet to
determine whether it will change its current tax treaty practice to
adopt the functionally separate entity approach.
Subdivision 815-C therefore reflects the approach to the
attribution of profits to PEs that is currently incorporated into
Australia’s tax treaties (the relevant business activity
approach).

4.20
Further, Australia’s tax treaties are generally based on the
OECD’s Model Tax Convention. The revised Commentary to
Article 7 (which deals with the taxation of business profits,
including the allocation of such profits to PEs) of the OECD Model
Tax Convention as it read prior to 22 July 2010 contains specific
references to the OECD Guidelines, and how they are to be used in
the context of attributing profits to the PE of an
enterprise. Within the confines of the relevant business
activity approach, this is the approach that is adopted by
Subdivision 815-C.

4.21
Because arm’s length conditions under Subdivision 815-B have
some relevance in identifying the arm’s length profits of a
PE, the documents that are relevant for identifying arm’s
length conditions under Subdivision 815-B are also relevant under
Subdivision 815-C.

4.22
Given the hypothesis that a PE is a separate and distinct entity,
arm’s length profits must be determined by applying by
analogy the principles developed for the application of the
arm’s length principle between associated enterprises (these
are articulated in the OECD Guidelines). This is done by
reference to the functions performed, assets used and risks assumed
by the enterprise in carrying on business at or through the PE and
through the rest of the enterprise.

4.23
Consistent with applying the Guidelines by analogy in attributing
profits to PEs, generally the references in the OECD Guidelines to
associated enterprises or related parties should be read in the
context of Subdivision 815-C to be references to
entities and their PEs dealing with each other as distinct and
separate entities.

Regulation making power in relation to
documents

4.24
Consistent with Subdivision 815-B, regulation making powers are
included to allow for modifications to the list of guidance
material under Subdivision 815-C. Requiring such
modifications to be prescribed by regulation strikes an appropriate
balance between ensuring ongoing consistency with developing
international arrangements while providing for Parliamentary
scrutiny of future developments.

4.25
The regulation making powers include the ability to prescribe
additional documents or parts of a document. These powers
ensure sufficient flexibility to prescribe further guidance
material that may be published by the OECD or by other
organisations that may be relevant for interpretive purposes in the
future. Such material might be supplementary in nature or
address issues that are not considered by the current OECD Guidance
material. [Schedule 2, item 2,
paragraph 815-235(2)(b)]

4.26
Material prescribed under either Subdivision 815-B or 815-C may
also be removed by regulation from the list of guidance material
for Subdivision 815-C. This allows material to be removed in
the event that it is no longer relevant to determining arm’s
length profits of a PE. [Schedule 2, item 2,
subsection 815-235(3) and
(4)]

4.27
It may be appropriate to remove a document where it is subsequently
revised in such a way that it is no longer relevant, or if an
alternate model or guidance material is adopted in the
future. The regulation making power may also remove a part of
a document. This power may be used, for example, where
Australia reserves its position on part of a document.

4.28
Regulations may also prescribe which documents, or parts of
documents, are to be used or removed in specific
circumstances. [Schedule 2, item 2,
subsection 815-235(5)]

4.29
An example of this may be where a document explains a specific
approach that should be adopted in relation to a certain
arrangement in a specific industry but would result in an
inappropriate outcome for similar arrangements in all other
industries. In such cases it may be appropriate to prescribe
that document as relevant guidance material, but confine its
application to particular arrangements or industries.
Alternatively, a regulation that removes documents specified from
the guidance provision may prescribe the circumstances in which
those documents are to be disregarded.

When does an entity get a transfer pricing
benefit?

4.30
An entity gets a transfer pricing benefit under
Subdivision 815-C in respect of the attribution of
profits to a PE of the entity if:

â¢
the actual profits attributed to the PE differ from the arm’s
length profits for the PE; and

â¢
had the arm’s length profits, instead of the actual profits,
been attributed to the PE, the entity would have received a tax
advantage in Australia.

[Schedule 2, item
2,
subsection 815-220(1)]

The actual profits differ from the arm’s
length profits

4.31
In determining whether an entity gets a transfer pricing benefit,
the actual profits attributed to the PE of the entity must differ
from the arm’s length profits. Arm’s length
profits are discussed in further detail at paragraphs 4.41 to 4.50
below. [Schedule 2, item 2,
paragraph 815-220(1)(a)]

The actual profits result in a tax advantage in
Australia

4.32
Subdivision 815-C requires an assessment of what an entity’s
Australian tax position would have been had the arm’s length
profits been attributed to its PE.

4.33
Assessing what the entity’s tax position would have been
requires a comparison between the arm’s length profits and
the actual profits. In order to have a transfer pricing
benefit, it must be demonstrated that the entity would have
received a tax advantage in Australia because of the actual profits
attributed to its PE, relative to the arm’s length profits
being attributed to its PE.

4.34
An entity has a tax advantage if the attribution of arm’s
length profits to its PE, relative to its actual profits, would
mean that one of the following applies:

â¢
the amount of the entity’s taxable income for the income year
would have been greater ;

â¢
the amount of the entity’s loss of a particular sort for the
income year would have been less ; or

â¢
the amount of the entity’s tax offsets for the income year
would have been less .

[Schedule 2, item
2,
subsection 815-220(1)]

4.35
Where a change in an amount of profit or component amounts of
profit (for example, certain amounts of revenue or expense) would
not have affected an entity’s Australian tax position, the
entity does not have a tax advantage of the kind referred to
above. For example, if an amount of profit that might have
been expected to have accrued to an entity would have been
non-assessable, non-exempt income of the entity, then the
entity would not have a transfer pricing benefit in respect of that
amount.

Calculating a transfer pricing benefit when
there is no taxable income, loss of a particular sort, or tax
offsets

4.36
An assessment of whether an entity receives a tax advantage of the
kind referred to above, as well as the amount of any such benefit,
requires consideration of the difference between two amounts: the
first being based on the actual attribution of profits to the
entity’s PE, and the second being the attribution of
arm’s length profits to the entity’s PE.

4.37
In instances where an entity has no taxable income, no loss of a
particular sort, or no tax offset in an income year, it is not
correct to say that the entity has a nil amount (rather it has no
amount at all).

4.38
To ensure that the necessary calculation can still be performed
where an entity has no actual taxable income, no losses of a
particular sort, or no tax offsets (or would not have had such an
amount under an attribution of arm's length profits to its PE), a
rule is included to deem the entity to have a taxable income, loss
of a particular sort, or tax offsets equal to an amount of nil (as
appropriate) in the income year. This allows the relevant
amount to be compared with the nil amount (or amounts).
[Schedule 2, item 2, subsection
815-220(2)]

Why is there no cross-border test in Subdivision
815-C?

4.39
Although Subdivision 815-C does not contain an express
cross-border test, the rules only have application where the
allocation of an amount to a PE has an impact upon an
entity’s tax position. Such an impact will only occur
in respect of dealings through a PE that have a cross-border
element.

4.40
For example, the attribution of amounts to an Australian PE of an
Australian resident does not affect the resident’s tax
position, whereas the attribution of amounts to a foreign PE of
such an entity has implications for their access to the foreign
branch income exemption or the business profits articles of a
relevant treaty. Conversely, the attribution of amounts to a
foreign PE of a foreign resident does not affect the foreign
resident’s Australian tax position, whereas attribution to an
Australian PE does (either because of the sourcing rules in
Australia’s tax treaties or the equivalent deeming provision
under subsection 815-225(3)).

What are the arm’s length
profits?

4.41
The arm’s length profits of a PE are worked out by allocating
the actual expenditure and income of an entity between itself and
its PE so that the profits attributed to the PE equal the profits
that the PE might be expected to make if:

â¢
the PE was a distinct and separate entity;

â¢
that separate entity was engaged in the same or comparable
activities under the same or comparable conditions; and

â¢
the conditions that operated between that separate entity and the
entity of which it is a PE were the arm’s length
conditions.

[Schedule 2, item
2, subsections 815-225(1) and
(2)]

4.42
Because the PE is taken to be an entity that deals with the entity
of which it is actually a part, the approach under Subdivision
815-B to determining arm’s length conditions is directly
relevant in ascertaining the arm’s length profits for the
PE. As such, any factors relevant to determining arm’s
length conditions under Subdivision 815-B may be directly
relevant to determining the arm’s length profits under
Subdivision 815-C. Similarly, the comparability
factors and the issues to have regard to under Subdivision 815-B in
selecting the most appropriate method may be relevant to applying
the arm’s length principle under Subdivision 815-C.

4.43
Comparable activities and circumstances should therefore be
identified having regard to all relevant factors, including the
factors mentioned in subsection 815-125(3). This is achieved
by determining the arm's length conditions based on the assumption
that the entity is a distinct and separate entity and engaged in
the same or comparable activities in the same or comparable
circumstances.

4.44
In determining whether an entity has attributed the arm’s
length profits to its PE, the economically relevant and material
characteristics of the situations being compared must be
sufficiently comparable. To be comparable, none of the
differences (if any) between the situations being compared should
be capable of materially affecting the arm’s length
profits.

4.45
Consistent with the approach adopted in Australia’s domestic
law and in Australia’s tax treaties, the arm’s length
profits must however be identified subject to the constraint that
the allocation is determined within the confines of the actual
income and expense position (as they apply for Australian tax
purposes) of the entity of which the PE is a part.

4.46
For the purposes of determining the arm’s length profits, the
actual expenditure of an entity includes losses or outgoings.
Similarly, the actual income of an entity includes any amounts that
would be assessable income of the entity. [Schedule 2, item 2,
subsection 815-225(3)]

Source rules for arm’s length
profits

4.47
Subdivision 815-C includes a deeming rule in relation to the
arm’s length profits of an entity’s Australian
PE. The effect of this rule is that the arm’s length
profits for that PE are taken to be attributable to Australian
sources. [Schedule 2, item 2,
subsection 815-230(1)]

4.48
This deeming rule is consistent with the special source rules
contained in Australia’s tax treaties and has the effect of
ensuring that any arm’s length profits of an Australian PE
are taken to be Australian sourced. Whether or not amounts
are Australian sourced is relevant for foreign residents as they
are taxed on their Australian sourced income. Similarly,
questions of source are relevant for foreign resident beneficiaries
of Australian resident trust estates and foreign resident partners
of partnerships.

4.49
A similar deeming rule is also included in respect of the
arm’s length profits of a PE located in an area covered by an
international tax sharing treaty. This rule deems any
arm’s length profits of such PEs to be sourced in the area in
which the PE is located. [Schedule 2, item 2,
subsection 815-230(2)]

4.50
This rule ensures that the arm’s length profits (which can
include income and expenditure) of the PE are taken to be sourced
in the area covered by the relevant international tax sharing
treaty. Although such areas may be within Australia, the rule
is relevant for all entities irrespective of residence because
Australia’s ability to impose tax upon income sourced in an
area covered by an international tax sharing treaty (or deal with
expenditure in relation to such income), is affected by the terms
of such agreements.

Time limits for amending
assessments

4.51
Under Division 13 and Subdivision 815-A, the Commissioner of
Taxation (Commissioner) had an unlimited period in which to make or
amend an assessment in relation to a transfer pricing
adjustment.

4.52
Subdivision 815-C introduces a time limit for amending
assessments. A transfer pricing adjustment to the tax
position of an entity as a result of the application of Subdivision
815-C must be made within seven years of the day on which the
Commissioner gives notice of the assessment to the entity.
[Schedule 2, item 2, section
815-240]

Subdivision 815-D

5.1
Subdivisions 815-B and 815-C make a number of
references to the taxable income or loss of a particular sort of an
entity. Because trusts and partnerships do not have taxable
income and partnerships do not have tax losses, special rules are
included in Subdivision 815-D to ensure that Subdivisions 815-B and
815-C apply appropriately to trusts and partnerships. These
rules address the differences in terminology but do not otherwise
change the substantive effect of Subdivisions 815-B or
815-C.

5.2
As such, where Subdivisions 815-B and 815-C apply in relation to
the taxable income of an entity, they apply in the same way to the
net income of an entity that is a trust or partnership.
[Schedule 2, item 2, section 815-305 and
subsection 815-310(1)]

5.3
Further, Subdivisions 815-B and 815-C apply to a partnership loss
of a partnership in the same way that they apply to the tax loss of
an entity that is not a partnership. Although the term
‘tax loss’ is not explicitly used in Subdivisions 815-B
or 815-C, those Subdivisions use the definition of ‘loss of a
particular sort’ which includes a tax loss but not a
partnership loss. As such, a partnership that has a
partnership loss is treated as having a loss of a particular sort
under Subdivisions 815-B or 815-C. [Schedule 2, item 2, subsection
815-310(2)]

Subdivision 284-E of Schedule 1 and other
amendments to the Taxation
Administration Act 1953

Link between record keeping and
penalties

6.1
A taxpayer is liable to an administrative penalty under the
Taxation Administration Act
1953 (TAA 1953) where the Commissioner of Taxation
(Commissioner) takes certain actions to give effect to Subdivisions
815-B or 815-C.

6.2
Whether or not a taxpayer has a reasonably arguable position in
respect of the way they had self-assessed their position under
Subdivision 815-B or 815-C prior to the Commissioner
determining that additional tax is payable by the taxpayer impacts
upon the amount of the administrative penalty. Where an
entity is able to demonstrate that its position was reasonably
arguable, the entity is entitled to a reduced penalty amount.

6.3
Subdivision 284-E of Schedule 1 to the TAA 1953 sets out the
records that an entity or the agent of the entity may prepare and
maintain in order to demonstrate that they have correctly applied
Subdivisions 815-B or 815-C. Records that
are kept in accordance with Subdivision 284-E are required
(but not sufficient) to establish a reasonably arguable position
about the application of those Subdivisions.

6.4
In the event that an entity is liable for a scheme shortfall amount
due to the application of Subdivision 815-B or 815-C, the entity is
only able to establish it has a reasonably arguable position if it
has prepared and maintained documentation in respect of the matter
that gives rise to the shortfall amount. To the extent that
it has not kept documentation in respect of such conditions, it is
unable to establish that it has a reasonably arguable position
about how the Subdivisions apply and is therefore unable to access
the lower scheme penalty amount should it be liable to a shortfall
penalty.

6.5
Although establishing a reasonably arguable position is one avenue
through which an entity can lower the applicable penalty amount,
the requirement that a taxpayer keep records under Subdivision
284-E has no impact upon the Commissioner’s general ability
to exercise a discretion to remit administrative penalties.

Interaction with section 262A of the ITAA
1936

6.6
Section 262A of the Income Tax
Assessment Act 1936 (ITAA 1936) imposes a general
requirement that a person who is carrying on a business keep
records that explain all transactions and other acts engaged in by
the person that are relevant for any purposes of the ITAA 1936
and the Income Tax Assessment
Act 1997 . It would be expected that to the extent
that documents prepared in accordance with Subdivision 284-E
relate to transactions or acts that would otherwise need to be
recorded under section 262A, the documents prepared in accordance
with Subdivision 284-E would satisfy the more general record
keeping requirement under section 262A. However where this is
not the case, section 262A continues to apply in respect of any
relevant transactions and acts.

Penalties for adjustments made under Subdivision
815-B or 815-C

When will penalties
apply?

6.7
Subdivision 284-C in Schedule 1 to the TAA 1953 imposes a liability
to an administrative penalty where the Commissioner takes certain
actions to give effect to Subdivision 815-B or 815-C that result in
a liability to an additional amount of income tax or withholding
tax. [Schedule 2, item 3,
subsection 284-145(2B) in Schedule 1 to the TAA
1953]

6.8
The relevant actions of the Commissioner are the amendment of an
assessment in an income year in respect of a liability to
additional income tax, or the serving of one or more notices that
additional withholding tax is payable. [Schedule 2, item 3,
subparagraphs 284-145(2B)(a)(i) and (ii) in Schedule 1
to the TAA 1953]

6.9
As such, if the Commissioner determines that a taxpayer has not
correctly self-assessed their tax position under Subdivision 815-B
or 815-C and amends an assessment or issues a notice in
respect of withholding tax, the taxpayer is liable to an
administrative penalty.

What is the amount of the
penalty?

6.10
Administrative penalties under Subdivision 284-C in Schedule 1 to
the TAA 1953 are determined by the scheme shortfall amount to which
the relevant adjustment relates. In the context of
adjustments made under Subdivision 815-B or 815-C, the scheme
shortfall amount is the amount of the additional income tax or
withholding tax payable as the result of the Commissioner taking
action against the taxpayer. [Schedule 2, item 4,
subsection 284-150(4) in Schedule 1 to the TAA
1953]

6.11
In most cases, the administrative penalty for transfer pricing
related scheme shortfall amounts is the sum of:

â¢
25 per cent of the scheme shortfall amount; and

â¢
10 per cent of the scheme shortfall amount to the extent it is
attributable to the taxpayer (or their agent) having treated the
transfer pricing rules as applying or not applying to a matter in a
way that was reasonably arguable.

6.12
However, where it is reasonable to conclude that the entity entered
into the scheme with the sole or dominant purpose of obtaining a
transfer pricing benefit (for themselves or another entity), the
base penalty amount is the sum of:

â¢
50 per cent of the scheme shortfall amount; and

â¢
25 per cent of the scheme shortfall amount to the extent it is
attributable to the taxpayer (or their agent) having treated the
transfer pricing rules as applying or not applying to a matter in a
way that was reasonably arguable.

6.13
Increased penalties in respect of schemes that were entered into
for the sole or dominant purpose of obtaining a transfer pricing
benefit are consistent with the former penalty provisions that
applied in relation to Division 13 of the ITAA 1936 (Division
13). Penalties in relation to adjustments under Division 13
only applied where penalties for the sole or dominant purpose of
obtaining a scheme benefit did not apply.

6.14
The base penalty rule for Subdivisions 815-B and 815-C includes
higher penalties in relation to sole or dominant purposes.
Accordingly, to the extent that a scheme shortfall amount is
attributable to the Commissioner giving effect to Subdivision 815-B
or 815-C, that amount is not included in a scheme shortfall amount
covered by subsection 284-145(1) (which applies to schemes
entered into for the sole or dominant purpose of obtaining a scheme
benefit). This carve-out ensures that taxpayers are not
subject to administrative penalties under both provisions in
relation to the same scheme. [Schedule 2, item 4,
subsection 284-150(5) in Schedule 1 to the
TAA 1953]

6.15
In addition to rules for transfer pricing related adjustments under
Subdivisions 815-B and 815-C, the base penalty rules for schemes
with the sole or dominant purpose of obtaining a scheme benefit and
for transfer pricing adjustments under Subdivision 815-A have been
rewritten into new subsections but have not been modified in
substance. [Schedule 2, item 3,
subsections 284-160(1) and (2) in Schedule 1 to the TAA
1953]

Scheme shortfall
amounts that are less than the reasonably arguable
threshold

6.16 Administrative penalties do
not apply in respect of Subdivisions 815-B or 815-C where the
scheme shortfall amount is equal to or less than an entity’s
reasonably arguable threshold. [Schedule 2, item 6,
subsection 284-165(1) in Schedule 1 to the TAA
1953]

6.17 Special rules also apply for
partnerships and trusts to ensure that administrative penalties in
respect of Subdivision 815-B or 815-C do not apply to scheme
shortfall amounts that result in a trust having a greater amount of
net income or a lesser amount of a tax loss, or a partnership
having a greater amount of net income or a lesser amount of a
partnership loss than the trust or partnerships’ reasonably
arguable threshold. [Schedule 2, item 6,
subsections 284-165(2) and (3) in Schedule 1 to the TAA
1953]

6.18
In instances where a trust or partnership has no net income, a
trust has no tax loss, or a partnership has no partnership loss, it
is not correct to say that the entity has a nil amount (rather they
have no amount at all). To ensure that the necessary
calculation can still be performed in such instances, a rule is
included to deem the trust or partnership to have net income, a tax
loss, or a partnership loss equal to an amount of nil (as
appropriate) in the income year. This allows the relevant
amount to be compared with the nil amount (or amounts).
[Schedule 2, item 6,
subsection 284-165(4) in Schedule 1 to the TAA
1953]

What is the reasonably arguable
threshold?

6.19
Amendments made to the TAA 1953 in relation to administrative
penalties remove the threshold references from items 4 to 6 of the
table to subsection 284-90(1) and insert them in the definition of
‘reasonably arguable threshold’.

6.20
The relevant thresholds are the greater of:

â¢
$10,000 or 1 per cent of income tax payable, or minerals resource
rent tax (MRRT) payable by an entity for the income year; and

â¢
$20,000 or 2 per cent of an entity’s net income for an income
year, where the entity is a trust or partnership.

[Schedule 2, items
45 to 48]

6.21
The definition of reasonably arguable threshold allows any future
changes to the general thresholds under section 284-90 of
Schedule 1 to the TAA 1953 to apply automatically for the
purposes of determining administrative penalties in relation to
transfer pricing adjustments.

Records for Subdivision 815-B and
815-C

6.22
Subdivision 284-E of Schedule 1 to the TAA 1953 sets out
requirements in respect of documents related to the application of
Subdivisions 815-B and 815-C.

6.23
Where an entity has treated Subdivision 815-B or 815-C as applying
or not applying to a matter in a certain way (or made a statement
about the way those Subdivisions apply to a matter), and the entity
does not have records that meet the requirements of Subdivision
284-E, the entity cannot have a reasonably arguable position in
respect of that matter. [Schedule 2, item 7,
section 284-250 in Schedule 1 to the TAA
1953]

6.24
In order to meet the documentation requirements of
Subdivision 284-E, the records must be prepared before the
time the entity lodges its income tax return for the income year,
and either be in English or be readily accessible and
convertible into English. [Schedule 2, item 7,
paragraphs 284-255(1)(a) and (b) in Schedule 1 to the
TAA 1953]

6.25 It is intended that an
entity only maintain and prepare documentation in respect of those
conditions that are both material and relevant to the application
of Subdivision 815-B and 815-C to them. In this regard, a
condition is material if it impacts upon the entity’s
Australian tax position, and is ultimately relevant where it is
subject to an adjustment by the
Commissioner.

6.26 Because compliance with the
documentation rules is not mandatory, it is expected that in
determining whether certain conditions are material or relevant an
entity will undertake a risk assessment of its cross-border
dealings and prepare and maintain transfer pricing documentation in
respect of those matters which could be the subject of dispute with
the Commissioner.

6.27 Where an entity has prepared
and maintained transfer pricing documentation in respect of a
matter that is the subject of a scheme shortfall amount, the entity
is entitled to establish that it had a reasonably arguable position
in respect of that matter (and therefore is eligible for a lower
administrative penalty). Conversely, in the event that an
entity does not have any documentation in respect of the matter
which is ultimately disputed by the Commissioner and results in a
scheme shortfall amount, the entity is unable to claim a reasonably
arguable position in respect of that
matter.

6.28 To the extent that an entity
considers that transfer pricing documentation should be prepared
and maintained in respect of certain matters, the documentation
must explain the way in which the relevant Subdivision was applied
to the matter, and why the application in that way best achieved
consistency with the relevant guidance
material. [Schedule 2, item 7,
paragraphs 284-255(1)(c) and (d) in Schedule 1 to the
TAA 1953]

6.29 The records must also
contain information in respect of the relevant arm’s length
conditions, as well as particulars about the method selected and
the comparable circumstances relevant in identifying the
arm’s length conditions. [Schedule 2, item 7,
paragraphs 284-255(2)(a) and (b) in Schedule 1 to the
TAA 1953]

6.30 As such, transfer pricing
documentation should also contain an explanation of all the steps
that are undertaken in identifying which method should be selected,
and the comparable conditions used in that
process.

6.31 In cases where the records
explain the application of the transfer pricing rules to a matter
(as opposed to the non-application of the rules), the records must
also explain the result of the application of the relevant
Subdivision and contrast this result with the outcome that would
have been achieved in the absence of the Subdivision being applied
(for example, the entity’s tax result under arm’s
length conditions relative to actual
conditions). [Schedule 2, item 7,
paragraph 284-255(2)(c) in Schedule 1 to the TAA
1953]

6.32 In cases where the records
relate to the application of Subdivision 815-B, the records must
also explain the actual conditions that are relevant to the matter
in question. [Schedule 2, item 7,
paragraph 284-255(2)(d) in Schedule 1 to the TAA
1953]

6.33 In cases where the records
relate to the application of Subdivision 815-C, the records must
also explain the actual profits and arm's length profits attributed
to the permanent establishment that are relevant to the matter, as
well as the particulars of the activities and circumstances of the
permanent establishment that were assumed as the result of the
entity being deemed to be a separate and distinct
entity. [Schedule 2, item 7, paragraph 284 255(2)(e) in
Schedule 1 to the TAA 1953]

Consequential amendments

What is the effect on the Controlled Foreign
Company provisions?

7.1
Section 400 of Part X of the Income Tax Assessment Act 1936 (ITAA
1936) is repealed by these amendments. Subsection 400(aa) is
re-written to ensure the Controlled Foreign Company (CFC)
rules continue to operate as intended when calculating the
attributable income of an eligible CFC. This section
specifies that for an eligible CFC the cross-border test is
not satisfied where the eligible CFC and the other entity (provided
it is also a CFC) are residents of the same listed country
(disregarding the residency test in section 383 of the ITAA
1936). [Schedule 2, item 18,
section 400]

7.2 Former subsection 400(a) is
not re-written because it is not required. The residency
assumption under section 383 means that a CFC is treated as an
Australian resident and the cross-border test satisfied in the same
way for that CFC as it is for any other resident entity. It
would be expected that in most cases the cross-border test would be
satisfied for the CFC because it would operate through an overseas
permanent establishment.

7.3 Former subsection 400(b) is
not rewritten because it has no practical effect in the context of
the new rules. That subsection related to consequential
amendments for entities as the result of the notional application
of Division 13 of the ITAA 1936 (Division 13) to a CFC in working
out its attributable income. In the event that an entity is
actually disadvantaged by the application of the new transfer
pricing rules, they are entitled to request a consequential
adjustment under those rules.

7.4
Amendments also modify the gross turnover calculation provisions in
the CFC rules to reflect the change in the transfer pricing rules
from operating on the basis of the Commissioner of Taxation
(Commissioner) making a determination under section 136AD of the
ITAA 1936, to the new rules operating on a self-assessment
basis. [Schedule 2, item 19, subsection
434(3)]

What is the effect on the transferor trust
rules?

7.5
Consequential amendments also repeal section 102AAZA, which
modified the way Division 13 applied in the notional application of
Division 13 to the trustee of a trust in calculating the net income
of the trust under the transferor trust rules. [Schedule 2, item 9, section 102AAZA in Schedule
1 to the TAA 1953]

7.6 Former subsection 102AAZA(a)
is not re-written because it is not required. The residency
assumption for the trustee that applies in the ordinary calculation
of the net income of a non-resident trust estate will mean that the
trustee is treated as an Australian resident. The
cross-border test is satisfied in respect of the trustee in the
same way that it is for any other resident
entity.

7.7 Former subsection 102AAZA(b)
is not rewritten because it is not required for the provisions
relating to consequential adjustments under Subdivision
815-B. That subsection related to consequential amendments
for entities as the result of the notional application of Division
13 to a trustee in calculating its net income under Division
13. In the event that an entity is actually disadvantaged by
the notional application of the new transfer pricing rules, it is
entitled to request a consequential adjustment under those
rules.

Amendment Period

7.8
Consequential amendments also repeal various provisions in Part IV
of the ITAA 1936 as a result of the removal of the unlimited
amendment period available to the Commissioner to give effect to
any transfer pricing adjustment. [Schedule 2, items 12 to 16,
subsection 170(9B), table item 4 in subsection 170(10),
subsection 170(9C), definition of ‘double taxation
agreement’ in subsection 170(14), definition of
‘prescribed provision’ in subsection 170(14),
definition of ‘relevant provision’ in subsection
170(14)]

Administrative
Penalties

7.10
A note is also included in provisions dealing with determining when
a matter is ‘reasonably arguable’ which directs
taxpayers to Subdivision 284-E of Schedule 1 to the Tax Administration Act 1953
(TAA 1953). This Subdivision sets out the requirements
for transfer pricing documentation [Schedule 2, item 44, note at end of subsection
284-15(1) in Schedule 1 to the TAA
1953]

7.11
A further amendment updates provisions that apply administrative
penalties to scheme shortfall amounts to ensure they may also be
applied where a liability to an administrative penalty arises under
subsection 284-145(2A) in Schedule 1 to the TAA 1953 from 1
July 2012. This amendment resolves an issue in calculating
the penalty amount for adjustments under Subdivision 815-A.
The change does not adversely affect taxpayers because Subdivision
815-A makes clear provision for penalties to apply in this
way. [Schedule 2, item 58, subsection
284-160(b) in Schedule 1 to the TAA
1953]

7.14
Amendments also reflect changes to references that have resulted
from the inclusion of additional Subdivisions within
Division 815. [Schedule 2, items 32 and 34, note in section
815-10, note in
section 820-30]

7.16
Amendments also insert new definitions into the dictionary for an
‘area covered by an international tax sharing treaty’,
‘arm’s length conditions’, ‘arm’s
length profits’, ‘international tax sharing
treaty’, ‘PE’, ‘reasonably arguable
threshold’ and ‘residence article’, while the
definition of ‘transfer pricing benefit’ has been
updated to incorporate amendments resulting from the modernisation
of the transfer pricing rules. [Schedule 2, items 36 to 43, subsection
995-1(1)]

7.17
In updating the IMR income provision to account for the repeal of
Division 13, a further technical amendment is also made to this
provision with the insertion of the words ‘that is resident
in a country’ to ensure that the provision applies only to
entities that are residents of countries that have not entered into
an international agreement with Australia which contains a business
profits article. [Schedule 2, item 35, subparagraph
842-250(1)(c)(ii)]

Application provisions

â¢
in respect of tax other than withholding tax — to income
years starting on or after the earlier of:

-
1 July 2013; and

-
the day this Bill receives Royal Assent.

â¢
in respect of withholding tax — in relation to income
derived, or taken to be derived, in income years starting on or
after the earlier of the above two dates.

[Schedule 2, items
50 and 54]

7.20
The amendment made by item 58 (which applies a base penalty to
scheme shortfall amounts) applies to income years commencing on or
after 1 July 2012. [Schedule 2, item
59]

7.21
Amendments to the Income Tax
(Transitional Provisions) Act 1997 reflect changes
that have resulted from the inclusion of the additional
Subdivisions within Division 815. In particular, the
amendments clarify that Subdivision 815-A does not apply to an
income year to which Subdivisions 815-B and 815-C apply.
[Schedule 2,
items 51 to 53]

STATEMENT OF COMPATIBILITY WITH HUMAN
RIGHTS

Prepared in accordance with Part 3 of the
Human Rights (Parliamentary
Scrutiny) Act 2011

Modernisation of the Transfer Pricing
Rules

7.22
This Schedule is compatible with the human rights and freedoms
recognised or declared in the international instruments listed in
section 3 of the Human Rights
(Parliamentary Scrutiny) Act 2011 .

Overview

7.23
Schedule 2 to this Bill inserts Subdivisions 815-B, 815-C and 815-D
into the Income Tax Assessment
Act 1997 and Subdivision 284-E into Schedule 1 to the
Taxation Administration Act
1953 . These amendments are designed to modernise
the transfer pricing rules contained in Australia’s domestic
rules.

7.24
The amendments provide a set of consistent rules that apply to both
tax treaty and non-treaty cases, ensuring greater alignment between
outcomes for international arrangements involving Australia and
other jurisdictions irrespective of whether they are part of
Australia’s treaty network.